Rights Issues and Dilution: How TERP and Nil-Paid Rights Work

A rights issue changes the share count, not free wealth

A rights issue lets existing shareholders buy newly issued shares, usually in proportion to their current holding and at a discount to the market price. The discount can look like an instant bargain, but the extra shares dilute the value per share mechanically. The correct starting point is the theoretical ex-rights price, or TERP.

Learning objective: calculate TERP and ownership dilution, understand nil-paid rights, and compare the practical choices to subscribe, sell, partly exercise or allow rights to lapse.

বাংলায় পড়ুন: Rights Issue ও Dilution: TERP এবং Nil-Paid Rights কীভাবে কাজ করে

HMRC defines a rights issue as an arrangement giving existing shareholders the right to subscribe for more shares in proportion to their holding. The subscription price is commonly below the existing market price.

1. Read the terms correctly

A one-for-four rights issue at £6 means an investor may buy one new share for every four existing shares by paying £6 for each new share.

The important terms are:

• the entitlement ratio;
• the subscription price;
• the record and ex-rights dates;
• the deadline for payment or sale;
• whether the rights are renounceable and can trade nil paid;
• how unused rights and fractional entitlements are handled;
• what the company will do with the proceeds.

The FCA's UK listing rules require a listed company to announce the issue price and principal terms and keep a rights offer open for at least ten business days (FCA UKLR 9.4).

2. Calculate the theoretical ex-rights price

Assume:

• four existing shares trade at £10 each;
• the company offers one new share at £6;
• there is no other market movement.

Before the issue, the four shares are worth 4 × £10 = £40. The shareholder adds £6, producing a theoretical combined value of £46 spread across five shares.

TERP = (£40 + £6) ÷ 5 = £9.20

The apparent £4 discount between £10 and £6 is not a £4 profit. After the extra capital and new share are included, the theoretical value of each share is £9.20.

A general formula is:

TERP = (value of existing shares + cash paid for new shares) ÷ total shares after the issue

TERP is a mechanical reference, not a price forecast. The market can trade above or below it because the use of proceeds, business outlook and market conditions change valuation.

3. Value the nil-paid right

In the example, the theoretical value attached to each existing share is:

Cum-rights price − TERP = £10 − £9.20 = £0.80

Four entitlements are needed to buy one new share, so the bundle's theoretical value is:

4 × £0.80 = £3.20

That also equals:

TERP − subscription price = £9.20 − £6 = £3.20

A renounceable entitlement may trade as a nil-paid right because the buyer acquires the right before paying the subscription price. Its actual market value can differ from the theoretical figure because of time, liquidity, costs and expectations for the ordinary shares.

4. See how ownership dilution works

Assume an investor owns 100 of a company's 1,000 shares, or 10%. A one-for-four issue creates 250 new shares.

If the investor subscribes fully

The investor buys 25 new shares and owns 125 of 1,250 shares:

125 ÷ 1,250 = 10%

The ownership percentage is maintained, although more capital has been invested.

If the investor does nothing

The investor keeps 100 shares while the total rises to 1,250:

100 ÷ 1,250 = 8%

The stake falls from 10% to 8%, a 20% relative reduction in ownership. Voting power and the claim on future earnings are diluted. Selling valuable rights can compensate for some economic dilution, but it does not preserve the voting percentage.

FCA prospectus rules require disclosure comparing ownership and voting participation before and after a capital increase when existing shareholders do not subscribe (dilution disclosure).

5. The main shareholder choices

Take up all rights

Pay the subscription amount and preserve the proportional holding. This increases exposure to the company, so the decision should still depend on valuation, balance-sheet risk and use of proceeds.

Sell the rights

If the rights are tradable, sell them nil paid before the dealing deadline. This can recover the entitlement's market value without committing more capital.

Take up some and sell some

An investor may use part of the entitlement and sell the remainder. A “tail swallowing” arrangement may sell enough rights to fund the exercise of the rest, subject to the offer and broker process.

Allow the rights to lapse

This risks losing value. Under UK listing rules, unused rights may be sold and a net premium may be paid to the holder, subject to the terms and a small-payment threshold. Never assume the broker or issuer will handle the deadline favourably; read the corporate-action notice.

HMRC notes that rights may be sold nil paid and that lapse proceeds or fractional-entitlement payments can be capital distributions (HMRC guidance).

6. Judge why the company is raising money

The arithmetic does not decide whether the issue is attractive. Analyse:

1. Use of proceeds: growth investment, acquisition, regulatory capital, working capital or debt repayment.
2. Balance sheet: whether the raise solves a temporary funding need or an unsustainable business model.
3. Underwriting: fees, conditions and who bears the risk of an undersubscribed offer.
4. Discount: a deep discount can improve participation but may signal urgency.
5. Earnings impact: whether the new capital can generate enough profit to offset the larger share count.
6. Management record: prior dilution, capital allocation and delivery against promises.

Calculate post-issue net debt, interest cover, shares outstanding and earnings per share under conservative assumptions.

7. Distinguish similar corporate actions

• Rights issue: existing holders receive proportional rights, often renounceable.
• Open offer: holders can subscribe, but the entitlement is commonly not tradable.
• Placing: new shares are sold to selected investors; existing holders may be diluted without a proportional offer.
• Bonus issue: extra shares are issued without a subscription payment; proportional ownership normally stays unchanged.
• Share split: each share is divided into more units without raising capital.

The label affects tradability, deadlines, tax treatment and the choices available to shareholders.

8. Consider tax and broker mechanics

Tax treatment depends on jurisdiction and circumstances. UK guidance says that, for qualifying share reorganisations, the cost of further shares acquired in a rights issue is added to the cost of the original holding (HMRC helpsheet HS285). Selling rights or receiving lapse proceeds can have separate consequences.

Also check whether the broker supports the election, the cash deadline, foreign-exchange conversion, fees, fractional rights and tax-advantaged accounts. The broker deadline may be earlier than the issuer's deadline.

Common mistakes

1. Treating the subscription discount as free profit. TERP incorporates the new shares and cash.
2. Ignoring the deadline. Rights can lose value or lapse if no instruction is submitted.
3. Doing nothing without checking tradability. An open offer entitlement may not be sellable.
4. Focusing only on percentage dilution. The quality and return on new capital also matter.
5. Using the old share price in valuation ratios. Recalculate shares outstanding and per-share figures.
6. Assuming TERP will be the market price. It is theoretical, not guaranteed.
7. Ignoring tax and broker rules. Account type and jurisdiction can change the outcome.

Practical checklist

• Read the ratio, subscription price and all deadlines.
• Calculate TERP and the theoretical value of each right.
• Calculate ownership with and without participation.
• Confirm whether the rights are tradable nil paid.
• Review the use of proceeds and post-issue balance sheet.
• Recalculate earnings, cash flow and net debt per share.
• Compare taking up, selling, partial exercise and lapse outcomes.
• Check broker procedures, fees, account rules and cash timing.
• Verify the applicable tax treatment.
• Decide before the broker's election deadline.

Key takeaway

A rights issue transfers value between the existing shares, the new shares and the entitlement; the headline discount is not free wealth. Use TERP to understand the mechanics, calculate ownership dilution and then judge whether the company can earn an adequate return on the new capital.

Educational information only. This is not personalised investment or tax advice and is not a recommendation to subscribe, sell or hold any security. Corporate-action terms vary, share prices can fall and capital is at risk.