Rights to Subscribe to Common Stock
This department is designed to help readers to a better understanding of the general business conditions which affect their investments. It is obviously impossible to give advice as to specific investments.
by HOWARD DOUGLAS DOZIER
A NOTE on a pad in front of me is to the effect that on August 3, 1929, ‘rights’ to subscribe to a new issue of common stock then being offered by a large public utility holding company, one of the largest in the country and one of the oldest, were quoted in the market at $3 13/16 each. These rights grew out of an offer by the company to sell to stockholders, and to stockholders only, some two million shares of its common stock at a figure considerably below the then prevailing market price. This was a ’privileged subscription.’ ’Rights’ were its offspring.
During the worst months of the depression no such offers of sale were made. But within the recent past some have been made; rights have again been quoted in the market, and, unless all signs fail, the time is now at hand when such transactions will again become common corporate occurrences.
Corporations now faced with heavy taxes on their undistributed surpluses, which belong to their stockholders, will tend to distribute them — that is, pay them out in dividends. Having thus lined the left-hand pockets of stockholders, boards of directors will explore right-hand pockets in order to discover and extract enough money to keep their corporations going. Privileged subscriptions, with their attendant rights to subscribe, are a convenient means of accomplishing this.
A number of other reasons also exist why it is sometimes wise to raise money from stockholders in this manner rather than from the general public in some other. In the first place, a sale of common stock adds nothing to the bonded or funded debt, and does not, therefore, increase the fixed interest charges which have to be met regardless of the amount of earnings. Next, such a sale as is here described tends to maintain intact a seasoned body of stockholders who have confidence in the success of the enterprise. This sometimes proves to be very valuable. Then too a sale of this kind gives stockholders who wish to convert a portion of their equity in their company into cash an opportunity to do so. To the others it gives a chance to extend their holdings on convenient terms, generally, though not always, through optional installment payments.
This process of raising money takes the form of what seems to be a bargain sale of stock to stockholders on a certain date — as, for instance, an offer to sell one new share at a sub-market price for each five old ones owned. This privilege of purchase has value — value realizable either through sale or through use with a given amount of money in payment for the new stock. This value is calculable, and while the theoretical value arrived at mathematically rarely coincides with the actual selling price in the market, it is the bench mark by which the latter is gauged.
Let us now see how it is that these rights come to have a monetary value, and what that value is in an assumed sale. In order to do so let us make use of a simple balance sheet such as the following: —
|Plant and equipment||$5,000,000|
|Goods on hand||1,000,000|
|Cash in till and bills due from others||500,000|
|Owed to other credito s||1,000,000|
|Owed to owners: 50,000 shares of common stock||5,000,000|
|Surplus and undivided profit||3,000,000|
Accountants and others who bore into the inward parts of corporate affairs have a term which they use to epitomize the conditions of companies. It is ’book value,’ and is found by the assumption of a hypothetical sale of all a corporation’s assets at what the company says they are worth, a hypothetical payment of all debts in the order of their legal sequence, and a distribution of what is left among the number of shares of common stock outstanding. To illustrate: if the corporation whose statement of condition appears above should be liquidated, what it owns would fetch $10,000,000, of which $2,000,000 would be required to pay off the bondholders and other creditors. This would leave $8,000,000 to be spread over the 50,000 shares of common stock, and would result in a book value of $100 per share.
When a corporation’s affairs are in as prosperous a condition as that revealed by this statement, and the security market is anything like normal, a board of directors may initiate a sale of stock to stockholders with every hope of success. Let us now suppose that such an offer is made and the terms are to sell stockholders of record on a certain date 10,000 shares of new stock at $125 apiece, each stockholder being entitled to buy one new share for each five old ones held. When the sale has been completed and the money collected, the new position of the corporation is as follows: —
|Plant and equipment||$5,000,000|
|Goods on hand||1,000,000|
|Cash in till and bills due.||500,000|
|Cash — new money from stock sale||1,250,000|
|Owed to other creditors.||1,000,000|
|Owed to owners: 50,000 shares of old stock and 10,000 of new||6,250,000|
|Surplus and undivided profit||3,000,000|
If the accountants should now liquidate this new situation they would have left, after paying all debts, $9,250,000 to be spread over 60,000 shares of stock. This amounts to a book value of $154.166 per share. The sale of the new stock under the plan has caused a per-share dilution in stockholder equity, and for this reason: the total stockholder equity has been increased to $9,250,000 from $8,000,000 by the addition of $1,250,000. This is an increase of 15 5/8 per cent. The number of shares outstanding, however, has been increased by 20 per cent — that is, from 50,000 to 60,000. The resultant decline in value is from $160 to $154,166, or $5,834 per share, the loss which a stockholder who took no action would suffer.
He does not have to sit back and suffer a loss, however. That ‘loss’ is worth $5,834 a share to him. He can sell each of his rights for this amount or he can take five of them, put them with $125, and buy a new share worth $154,166. In case he should do the latter, his five rights would do $29,166 worth of the paying. He who sells his rights converts some of his equity in his corporation into cash; he who exercises them increases his holdings in his company. Neither suffers a loss or gets something for nothing. He who does nothing loses $5,834 a share. In the sale to which reference was made in the beginning, stockholders through Inaction unknowingly suffered a loss of nearly a millon dollars.
When a sale of this sort takes place, some stockholders generally want to convert their rights into cash; others want to exercise them and buy new stock if they can raise the money. Upon the announcement of the sale a market develops for the rights growing out of it. Before they are actually issued they are bought and sold on the curb on a ‘when issued’ basis. Contracts for future delivery are entered into to be closed out when the rights become available. When they do become available they are dealt in on the exchange or exchanges on which the stock itself is listed. Those who have comparatively large blocks of rights which they desire to sell or those who want to buy such blocks can conveniently resort to these markets. During the progress of the sale, which usually continues for several weeks, the old stock, the new stock on a ‘when issued’ basis, and the rights going with the old are dealt in on the same exchanges.
For the accommodation of another class of buyers and sellers of fractional warrants the corporation conducting the sale frequently establishes a little market in its own offices. Many stockholders will not own just the number of shares necessary to enable them to buy an exact number of new shares at the reduced price. For instance, the owner of eight shares, and therefore eight rights, would find it necessary to dispose of three of the latter and, with the remaining live and $125, buy one new share, or else buy two rights and, with the ten then in his possession and $250, buy two new shares. It is quite likely too that a fairly large number of stockholders will not own as many as five old shares. This group will want to sell all their rights or buy enough to bring the number up to five so that they can use the five and $125 to buy one new share. A market for fractional warrants maintained by the company is a matter of great convenience to all these.
As we have already seen, the owner of stock cannot sit still and do nothing without sustaining a loss. If he decides to exercise his rights rather than sell them, he is faced with the problem of raising the money with winch to supplement them in order to make the purchase. There are a number of ways of meeting this very practical problem growing out of the privileged sale. It must be remembered that the sale is timed when the corporation needs the money, not when the stockholder has it waiting and seeking investment. If the stockholder does not have the money and cannot raise it any other way, he can always sell enough of his old shares to pay for the number of new ones which he is entitled to buy, and in this case his investment in the company is neither increased nor decreased. If he wants to be rid of all the worry, he can sell all his old stock, put the money away, and later, after the new stock is on the market or the sale is over, buy as many shares as his funds will purchase. This method of meeting the difficulty has its drawbacks. It involves a selling commission, a buying commission, the keeping of the funds in the meantime, as well as taking a chance on the market.
In a great many cases, perhaps most, it will always be possible to finance the purchase of new shares without selling old ones. Installment payments have already been mentioned as a way frequently adopted by the company for the accommodation of those who do not have the ready funds. As companies acquire the habit of making offerings of this kind, stockholders can lay aside dividends paid in order to escape the tax on undistributed surplus, and create a special ‘rights’ fund.
If one really believes in his corporation and is convinced of the wisdom of owning stocks at a particular time as against owning other types of assets, the best solution of the problem created for the stockholder by a privileged offering is to tighten up his belt a hole or two and save enough money to exercise his rights and thus increase his holdings.