What is a rights issue of a share? Who is it given to?

A company gives its existing shareholders 'a right' to buy new additional shares at a discounted price. The existing shareholders get a time period to decide if they want to exercise the right or not since this is an option and not mandatory.

What does a rights issue look like? 

Imagine it's 2015 and you are an employee in a firm and are thinking of starting a business on the side. 3 of your best friends help you to set up your business in the initial years and over a period of time, you make it a profitable venture. You have a 40% stake in the business while your three friends each have a 20% stake each, and for the last 7 years, all four of you have taken all business decisions together. 

Today you want to invest in a new project or create a new product. Now that you need funds of Rs 12 lakh, who will you talk to first? Your three shareholders/BFFs or someone new who is lesser involved in the business? Your loyal existing shareholders/BFFs right? 

Say you approach your best friends and tell them all about the new project. When you ask them if they are interested in investing, you are giving them the first priority to invest more capital into your business. You think they might be interested since they know how you work, how amazing your ideas are, and how well you execute them.

So, you essentially give them a right to invest. But of course, it's not compulsory. They can pass on the offer if they don't want to invest their money. But they have about a week to think.

In a week's time, all of the 3 best friends agree to invest more capital into the business. Why? Well, all three believed that in order to keep this company in order, they all needed an equal voting share. They each had a 20% share and if you would get someone else on board instead of them, that would mean:

• Their 20% stake would reduce based on how many new investors were coming in.
• If your company did well in the future, they would make lesser profits since their shareholding had reduced.
• Someone else would take their profits and they would regret their decision.
• They will also have to deal with someone new. Who knows what they will be like?
• Also, they will get these shares for a lesser price today.  

So your friends agree to get on board. 

Though your company's shares are being traded at say Rs 500 on the stock market today, you decide that you will allot new shares to your best friends at Rs 450 per share. 

You can issue two kinds of rights- renounceable and non-renounceable. Say you issue renounceable rights. This means that if one of your friends wants to sell these ''rights'' to someone else, they can. Say one friend sells the ''rights'' to Pinto and makes some money on the rights. Now Pinto will give you his money for the shares and be the owner of the new shares that you issue. This means that Pinto will join you and your 3 BFFs on the shareholder's list. 

This is what a right issue is.

Some more points

• Usually, if the investors think highly of the company, they end up buying the right issue shares. Why pay a higher price for the same shares on the stock market later on when you can get them at a discount now? 
• The company generally gives a host of reasons for raising capital through the right issue. If you are looking to invest in a company through a rights issue, check the reasons why the company is raising money, to understand if your investment will generate a good return or not.