A negotiable certificate entitling its holder to purchase a certain amount of a new issue of shares at a fixed price, usually below the current market price, is a subscription right, it allowing existing shareholders to subscribe before the shares are offered to the general public.  Normally, one right is issued for each share currently held.

Shareholders who receive subscription rights may take one of the following actions:

  1. Exercise the right, thereby maintaining proportionate interest;
  2. Sell the rights certificate and profit from its market value; or

Let the right expire, thus reducing proportionate ownership and losing the value of the right or of the stock it could have been used to acquire, if any.

When subscription rights are exercised and a company issues the underlying shares, the balance sheet changes in two ways:

  1. Cash and/or another asset account for cash not yet received for subscriptions increases by the amount of the net sales proceeds; and
  2. The paid-in capital accounts (i.e., capital stock and paid-in surplus) in the owners’ equity section increase on the opposite side of the balance sheet by a corresponding amount.

The increase in owners’ equity resulting from a rights offering equals the number of shares subscribed to times the stock’s par or stated value plus the total amount paid for the stock in excess of par.

Dilution of ownership is the reduction in each current shareholder’s fractional ownership in the company resulting from the issuance of additional shares of common stock in a rights offering or the exercise of a subscription warrant and/or the conversion of convertible securities.  This reduces each shareholders company control and voting percentage as well as earnings and net worth per share.  Furthermore, an increased supply of stock available to the market normally cause the stock’s market price to decrease proportionately, while increasing the liquidity of the stock.

Dilution of Control = Number of New Shares/Number of Old Shares + Number of New Shares
Real Dilution = Proceeds of Capital Increase/(Equity Value before Capital Increase + Proceeds of Capital Increase)

Capital Increases and Dilution of Control
1.     If the equity’s market value is approximately equal to its book, the dilution of control will be accompanied by a proportionate increase in the company’s overall financial resources.
2.     If the equity’s market value is greater than its book value, the dilution of control will result in a greater increase in financial resources.
3.     If the equity’s market value is less than its book value, the shares are issued for noncash consideration.

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