Subscription Right: Definition, How It Works, and Example

What Is a Subscription Right?

A subscription right is the right of existing shareholders in a company to retain an equal percentage ownership by subscribing to new stock issuances at or below market prices. The subscription right is usually enforced by the use of rights offerings, which allow shareholders to exchange rights for shares of common stock at a price generally below what the stock is currently trading for.

Subscription rights are also known as the "subscription privilege," "preemptive right," or "anti-dilution right" of the shareholder. A subscription rights issue increases the number of shares in the market, thus leading to a dilution in each share's value.

How Subscription Rights Work

Subscription rights are not necessarily guaranteed by all companies, but most have some form of dilution protection in their charters. If granted this privilege, shareholders may purchase additional shares on a pro-rata basis before they are offered to the secondary markets. This form of dilution protection may be good for up to 30 days before a company seeks new investors in the broader market.

If shareholders do not exercise their subscription rights, their ownership will be diluted. Most subscription rights are not transferable unless allowed by the issuer. If they are transferable, they can be traded on an exchange. Also, oversubscription privileges are offered in some cases whereby shareholders who have fully exercised their rights can subscribe to additional shares, again on a pro-rata basis.

Investors receive notification of their subscription right by mail (from the company itself) or through their brokers or custodians.

Criticism of Subscription Rights

While the issuing of subscription rights may represent an opportunity for existing shareholders to buy more shares at a discounted price, there are some disadvantages to subscription rights. The main disadvantage is that shares become diluted when a company raises capital by making a secondary offering. Unless the shareholder exercises their subscription rights and purchases additional shares, their ownership will be diluted.

Also, the announcement of the secondary offering often leads to a decline in share price as some investors respond to the news by selling off the stock. The prospect of a share dilution will generally be negative to a stock price and to the original investors' sentiment.

There are several warning signs investors should be aware of that might indicate a company is considering rolling out a secondary offering. For example, if a company is having difficulty raising money to cover expenses or fund large projects, management might decide to issue new stock to cover the emerging capital and debt needs. Investors need to watch for the signs of potential share dilution and understand how this might impact their investments.

The dangers of share dilution can also occur when a company issues stock options to employees or board members. Additionally, share dilution can occur as part of a dilutive acquisition when a company needs to issue additional shares in order to pay for the purchase of another company.

Example of a Subscription Right

Subscription rights offerings can be structured in a number of ways. On Dec. 22, 2017, Schmitt Industries completed an offering in which 998,636 common shares were issued. The company issued one right for each common share, and holders of the rights were entitled to purchase common shares by exchanging three rights and $2.50 for each share desired. The offering was oversubscribed, and available oversubscription shares were allocated pro-rata among those who fully exercised their rights in the original offering.