From time to time, shareholders are invited to participate in rights offerings, which typically involve the ability to purchase more shares of stock at a discounted price. In assessing who receives those rights, companies set a date on which they'll distribute the rights to current shareholders. Once that determination has been made and the shareholders eligible to receive the rights have been identified, the stock is said to trade ex-rights. After that point, if you buy the stock, you're entitled only to the shares you purchase and not to the rights that might otherwise come with them. If you sell the stock after the ex-rights date, you're still entitled to the rights when they're issued.
Why companies do rights offerings
Rights offerings, which are also sometimes called rights issues, are a way for companies to raise more capital. Sometimes, companies will use the proceeds from rights issues to pay down debt, while in other cases, the money might go toward an acquisition or other purpose.
The structure of the rights offering prevents shareholders from having their interest diluted against their will. The distribution of rights occurs in proportion to your holdings of shares, so if you owned 1% of the outstanding shares of the company, you'd get rights equal to 1% of the total new shares offered by the company.
Why you need to know if a stock trades ex-rights
The key to the rights issued by a company is that they have their own value. Investors can buy and sell rights between the time they're issued and the final exercise date set under the rights offering.
Therefore, if shares of stock trade with rights, then they're more valuable than if they trade ex-rights. Being able to exercise the rights and buy shares at a discount gives the rights holder an immediate gain in value, and clearly, selling the rights will essentially give the holder free money.
What to do with stocks that have rights offerings
Investors should keep in mind that there are three things they can do with rights: buy the shares that the rights entitle you to buy, sell the rights, or simply ignore them. Ignoring your rights is usually the worst thing to do, because you miss out on getting some value from the rights. However, if the stock has fallen sharply in value so that subscribing to purchase more shares doesn't make sense at the specified price, then letting rights expire worthless is sometimes the right move.
In some ways, it can be easier to wait until a stock trades ex-rights before buying it. Typically, the share price will fall after the rights holders are determined, making it cheaper to buy the stock ex-rights. You can simply by the number of shares you want without worrying about selling rights or subscribing for more shares.
Nevertheless, when a stock you own does a rights offering, it's important to know when the stock trades ex-rights. Otherwise, you could make a mistake in determining whether to sell your stock or hold onto it through the rights offering.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at firstname.lastname@example.org. Thanks -- and Fool on!