What Are Subscription Rights and How Do They Work in Finance?

Companies sometimes offer existing shareholders the chance to buy additional shares at a set price before selling them to the public. These subscription rights help investors maintain or increase their ownership while potentially acquiring shares at a discount.

Understanding how subscription rights work helps investors decide whether to exercise, sell, or let them expire.

Role in Equity Issuance

Subscription rights allow companies to raise capital while giving existing shareholders a way to protect their investment. Instead of seeking external financing, a company can issue new shares through a rights offering, raising money without taking on debt. This approach is useful for businesses looking to expand, invest in research, or strengthen their balance sheet.

By offering these rights, companies prevent dilution for participating shareholders. If new shares were sold directly to the public, existing investors would see their ownership percentage shrink. Rights offerings give them the first chance to buy additional shares, often at a discount, encouraging participation and ensuring the company secures the necessary funds.

The structure of a rights offering varies. Some companies issue rights on a one-to-one basis, meaning each existing share entitles the holder to buy one new share. Others may offer fractional rights, requiring investors to hold multiple shares to acquire one new share. The subscription price is typically set below market value to attract investors, but if the discount is too small, participation may be low.

Eligibility Requirements

Only shareholders who own stock as of a specified record date qualify for subscription rights. Investors who buy shares after this date do not receive rights, even if they purchase stock before the offering begins.

The method of holding shares also affects eligibility. Investors who own stock directly through a brokerage account or in certificate form automatically receive rights if they meet the record date requirement. However, those who hold shares through mutual funds or exchange-traded funds (ETFs) may not receive rights, as fund managers, not individual investors, are considered the shareholders of record. In such cases, the fund decides whether to participate.

Companies may also impose restrictions based on regulatory and legal considerations. Some rights offerings exclude shareholders in certain jurisdictions due to securities laws requiring additional disclosures or approvals. U.S. companies, for example, may exclude international investors if complying with foreign regulations is too complex or costly. Similarly, companies in regulated industries, such as banking or telecommunications, may limit rights offerings to prevent investors from exceeding ownership thresholds.

Transferability

Subscription rights can be either transferable or non-transferable. Transferable rights allow shareholders to sell them on the open market, similar to common stock. This lets investors extract value even if they choose not to participate. The price of these rights depends on factors such as the discount to market price, demand, and time remaining before expiration. Rights with a larger discount tend to be more valuable, as they offer a greater arbitrage opportunity.

Non-transferable rights limit investors to either exercising them or letting them expire. Companies may use this structure to ensure only existing shareholders benefit, preventing outside investors from buying rights in the secondary market. While this protects long-term shareholders, it removes the option to recover value if an investor does not want to buy additional shares. For those without the capital to participate, non-transferable rights can result in lost potential gains.

The trading period for transferable rights is usually short, often lasting only a few weeks. Investors looking to sell must act quickly, as the value of rights declines as expiration approaches. If the stock price falls below the subscription price, the rights may become worthless, as no investor would pay more than the market price for the shares.

Effects on Ownership Levels

Exercising or ignoring subscription rights can change a shareholder’s ownership percentage, especially if participation rates vary. If many shareholders decline to exercise their rights, those who do participate can increase their stake. This effect is more pronounced when major institutional investors or insiders take advantage of the offering while retail investors opt out.

When certain shareholders increase their stake by purchasing unsubscribed shares, it can shift voting power and influence within the company. This is particularly relevant in companies with concentrated ownership, where a rights offering could allow a major investor to solidify control. Some companies include oversubscription privileges, allowing shareholders who fully exercise their rights to buy additional shares that were not claimed by others.

Tax Considerations

The tax treatment of subscription rights depends on whether they are exercised, sold, or allowed to expire.

When rights are exercised, the cost basis of the newly acquired shares is determined by adding the purchase price to either the fair market value of the rights (if they were originally taxable) or a zero-cost basis (if the rights were granted tax-free). In the U.S., the IRS generally considers rights granted to shareholders as non-taxable unless they have a readily ascertainable market value. If taxable upon receipt, their value must be reported as income.

Selling subscription rights triggers capital gains tax, with the gain or loss calculated based on the difference between the sale price and the cost basis. If the rights were received tax-free, the entire sale amount is considered a capital gain. The holding period of the rights, which determines whether the gain is taxed at short-term or long-term rates, usually follows the holding period of the original shares. If rights expire unused, there is generally no tax consequence unless they had an assigned cost basis, in which case a capital loss may be recognized.

Accounting for Subscription Rights

Companies issuing subscription rights must properly record the transaction to reflect changes in equity and comply with financial reporting standards. The accounting treatment depends on whether the rights are classified as equity instruments or liabilities under frameworks such as U.S. GAAP or IFRS.

When rights are issued, they are typically recorded as a memorandum entry rather than a financial statement transaction, as no immediate cash inflow occurs. Once shareholders exercise their rights and purchase shares, the company records an increase in cash and common stock, with any excess over par value allocated to additional paid-in capital. If rights are transferable and traded on the market, companies may need to disclose their fair value in financial statements, particularly if they impact earnings per share calculations.

For companies issuing rights with complex terms, such as contingent pricing or embedded derivatives, additional accounting considerations apply. Under IFRS, rights classified as financial liabilities may require mark-to-market adjustments, affecting reported earnings. Under U.S. GAAP, equity-classified rights generally do not impact net income but may require disclosure of potential dilution effects.

Timeline to Exercise

The window for exercising subscription rights is limited, requiring shareholders to act within a set period. Companies typically set a subscription period lasting between two to four weeks, during which investors must decide whether to participate. The short timeframe ensures the company raises capital efficiently while minimizing market fluctuations that could affect the offering’s success.

Once the subscription period ends, any unexercised rights become void, and the company finalizes the issuance of new shares. Some offerings include an oversubscription privilege, allowing shareholders who fully exercise their rights to buy additional shares that were not claimed by others.