Share Purchase Rights vs. Options: An Overview
Share purchase rights and options contracts have similar features, but there are distinct differences between these two financial offerings. Holders of share purchase rights may or may not buy an agreed number of shares of stock at a pre-determined price, but only if they are an existing stockholder.
Options, on the other hand, are the right to buy or sell stocks at a pre-set price called the strike price. Unless otherwise stated, the buyer is under no obligation to do so, but the buyer would have forfeited the fee or premium that comes when buying an option. Option buyers do not necessarily have to be existing shareholders.
In effect, an outsider buys the right to purchase stock via an option; with share purchase rights, that right is already inherent for existing stockholders. In either case, there is an agreed-upon time frame to consummate the deal.
The distinctions between share purchase rights and options also hold true outside the financial markets, including with big-ticket items, such as real property, yachts,and airplanes.
Key Takeaways
- Purchase rights are offers to existing shareholders to buy additional shares in proportion to the number of shares already owned.
- Purchase rights might allow shareholders to buy at a below-market price.
- Options contracts are traded on exchanges and give holders the right, but not the obligation, to buy or sell a security.
- Options contracts are typically available to all investors unless they're employee stock options, which are given to employees as an incentive.
Purchase Rights
Purchase rights are offers to existing shareholders to buy additional shares in proportion to the number of shares already owned. Sometimes the right to purchase might be at a below market price for the stock. Investors that have purchase rights can let the rights expire or trade them to another shareholder if they don't want to increase their investment in the company.
Although it might appear like a great deal, purchase rights can also lead to a lower stock price for a company since the rights issue can dilute the outstanding shares. Also, exercising purchase rights can lower a company's earnings per share (EPS). Earnings per share are the profit from a company divided by the outstanding shares.
For example, if a company has posted a $1 earnings per share with ten shares outstanding and issues another ten shares, the EPS drops down to 50 cents per share. As a result of a lower EPS, investors might sell the stock.
Companies might issue share purchase rights if they have a significant amount of debt and need to raise additional capital. A company might use the funds from the rights issue to pay down debt.
Startup companies also issue purchase rights since it's often difficult to obtain financing from banks when a company has yet to turn a profit. For example, a company announces the development of a consumer product that is expected to take the world by storm, such as a virtual reality headset no bigger than a pair of sunglasses. Initial estimates are for the product to be a huge success, and the stock price is forecasted to take off. The company's management might offer existing shareholders purchase rights, and those who exercise their rights for the additional shares will benefit if the product is successful, and the stock's price rises. Conversely, if the product launch is a failure, the investor can take on losses from the investment.
Investors who have been offered purchase rights must weigh the pros and cons and decide if the company is using the money properly, and is worth the additional investment.
Options
Options contracts are traded on exchanges and give holders the right, but not the obligation, to buy or sell a security. Options contracts are typically available to all investors.However, companies might issue employee stock options (ESOs) internally as incentives and allow employees to participate in the ownership of the company. ESOs align the goals of employees and shareholders of a company since shareholders, including employees, want to see the company's stock price rise.
With employee stock options, a person might have to wait for a period before exercising the right to buy the shares. The vesting period encourages employees to remain with the company and is usually anywhere from one to three years.
With employee stock options, employees don't have to pay a fee for the option and there's no cash outlay. On the other hand, an options contract involves a fee or premium and if exercised, will involve the exchange of cash for the underlying shares.
Purchase rights are similar to traditional options contracts in that the investor must exchange cash for the shares if exercised. However, an employee stock option has no cash outlay since the company gives away shares.
One of the main benefits to purchasing rights, despite the cash outlay, is that the rights are typically offered at a below-market-value price allowing the investor the potential to earn a profit as a reward for being a loyal shareholder. Of course, whether an investor uses options contracts or purchase rights to invest in a company, there is always the risk of a loss, and investors must weigh the risks and rewards carefully.
