Wednesday, August 30, 2017

Rights offerings

Rights offerings

The Canadian government has made doing discounted rights offerings easier then ever and yet only a few companies have utilized this feature.

There are websites that describe these types of offerings. If a person is eligible to participate, there will be circular's and documents that also describe how they work and what to do.

The core logic and concept behind these offerings can be lost quite quick without a simple understanding of them.

Robert Friedland, a billionaire tycoon, has struggled to convince Canadians as to why they are good product and that more companies probably should use them.

Here is an article from 2013 with some nice quotes from Robert Friedland -- Article


"Idiots in Canada do not understand rights offerings are not dilution.. Everyone participates equally.. Rights offerings are the fairest form of equity finance ever developed by the human mind."

"Consider picking up a few shares [of Turquoise Hill] as a speculation… Pack them away for your favourite nephew."

"People should buy the rights and exercise them hand over fist"

Rather then explain in detail how and what these offerings are, a simple story will probably be of more here is the story:

Three kids show up one day. The names of the children are Charlie, Morgan, and Taylor.

Charlie comes up with a concept to start a lemonade stand service. Each of the three children invest $1 into the business or a total of $3. They in turn, get 1/3rd of the business in ownership and they each create 1 share certificate for each one of them.

They do a lot of research, a lot of planning and end up buying all the materials needed for the lemonade stand. This would include pieces of wood, nails, cups, etc.

The day of launch has come and each of the children are very excited....but Morgan has some bad news....all the money is spent and the lemonade stand has no lemons.

They all get together and comb through pockets, etc. and each come up with a single dime. They each give the company 10 cents and they each get 1 more share each in the company. At this point, they each own 1/3rd of the company and they all have 2 shares each. This is a fair transaction and all shareholders maintain ownership and the company can now buy some lemons and sugar to launch the business.

A 4th child arrives at the scene. That child's name is Tatum and Tatum wants to get involved in the business as Tatum sees it as a great business opportunity.

Tatum goes up to both Charlie and Morgan and neither one of them want to sell any shares in the company.

Taylor on the other hand has decided that a good deal is a good deal is a good deal. Taylor offers the most recent share to Tatum for 15 cents. Tatum immediately pays Taylor 15 cents and knows it is a great deal.  Taylor is super, super happy to have just made a 50% gain on that single dime investment.

Where are the shares now?

Charlie - 2 shares (1/3rd of company)
Morgan- 2 shares (1/3rd of company)
Taylor - 1 share (1/6th of company)
Tatum - 1 share (1/6th of company)

The company has a great first week, so much so...that an entity has offered to buy the whole company for $9 or $1.50 per share. All 4 children are very, very happy.

They get together and vote yes to the deal.

Charlie walks away with $3 and makes an excellent 170% off the original $1.10 investment.
Morgan does the same.
Taylor walks away with $1.65 ($1.50 plus $0.15 from Tatum) and makes 36% off the original $1.10 investment.
Tatum walks away with $1.50 and makes a  whopping 6600% off the original $0.15 investment.

Why did Taylor make only 36%? What did Taylor do wrong?

Taylor made a mistake of assuming the strike price of the discounted rights offering should be considered market price. If they had found only a nickel in their pockets, they may have had to buy less lemons and sugar...but could still launch the business. The price of the discount is not relevant here, the key to the business was to buy lemons and sugar otherwise the business was in trouble.

What should have Taylor done?
A fair value of the price would have been to take the 2 shares and find the average of the price. $1 plus $0.10 divided by 2 = $0.55.

Taylor should have offered Tatum 55 cents for 1 share in the company or maybe even 50 cents if Taylor needed the money....but assuming the strike price of the 2nd share (10 cents) equals fair value was a big mistake and Taylor paid for it with lack of gains.

This mistake does continue to be made in the Canadian market place and a very artificial opportunity to support a Tatum purchase can prevail. Keep an eye out for Canadian rights offerings and with this core logic in hand...maybe some good opportunistic investments could be at hand.

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