Latest / How Canadian Markets Work / Episode 53: Rights and Warrants (The Cost of Doing Nothing)

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Episode 53: Rights and Warrants (The Cost of Doing Nothing) · How Canadian Markets Work

0:00
So what if I told you that throwing away a piece
0:04
of unopened junk mail from your brokerage is,
0:08
mathematically speaking, identical to taking
0:10
$320 out of your wallet and just handing it to
0:14
a complete stranger? I mean, it sounds totally
0:16
absurd when you frame it like that. Right. But
0:18
it is the literal mathematical definition of
0:21
a financial self -inflicted wound. Wow. Because.
0:24
We are conditioned by modern life to just ignore
0:27
bureaucratic noise. And the market absolutely
0:30
preys on that conditioning. Yeah, and the worst
0:33
part is it happens in total silence, like nobody
0:35
calls you. You don't get a fraud alert on your
0:38
phone. The money just, well, it just vanishes.
0:40
It really does. Which is exactly our mission
0:43
for this deep dive. Today we are cracking open
0:45
a stack of sources covering corporate issued
0:47
instruments, specifically rights and warrants.
0:49
We're going to break down how they work, why
0:51
ignoring them actively deletes your wealth through
0:54
what we're calling the inertia tax, and how to
0:57
spot the massive, crucial difference between
0:59
a genuine market opportunity and stealthy corporate
1:03
dilution. It's a really fascinating structural
1:05
quirk of the financial world. These specific
1:09
instruments don't just appear out of the ether.
1:12
They are created by the very companies you already
1:15
own. So understanding how they function is literally
1:19
the difference between defending your slice of
1:21
the pie and accidentally paying for someone else's
1:24
lunch. OK, let's unpack this. Because we need
1:27
to start with the most urgent piece of mail you
1:31
can possibly get as an investor, which is a rights
1:33
offering. Yeah. So the sources define this as
1:36
a pro rata capital raise. And in plain English,
1:40
I mean, this is a company you already hold stock
1:42
in announcing, hey, we need more cash right now,
1:44
and we are giving our current shareholders the
1:47
very first chance to buy new shares at a discount.
1:49
Exactly. And pro rata just means your place in
1:52
line is based proportionally on what you already
1:54
own. That's right. So if I own, say, 1 % of the
1:57
entire company, I get the right to buy 1 % of
2:01
the new shares they're selling. That is the core
2:03
mechanism. It is theoretically designed so that
2:05
if you participate and you buy your allotted
2:08
shares, your overall percentage of ownership
2:10
in the company remains exactly the same. Okay.
2:13
You aren't diluted. But the engine driving this
2:17
entire event, the thing that catches everyone's
2:19
eye, is that discount. Right. They are offering
2:22
you brand new shares at a price significantly
2:25
below the current market value. OK. And right
2:29
here is where my brain hits a speed bump. Because
2:32
if a company I already own is offering me shares
2:34
at a 20 % discount, Isn't that just a gift? It
2:37
definitely feels like one. Yeah, like, why wouldn't
2:39
everyone take it? It just sounds like free money
2:42
being handed out to loyal shareholders. It masquerades
2:45
as a gift, for sure. But structurally, it's a
2:47
safety margin. A safety margin. Yeah. Think about
2:50
it from the perspective of the company's board
2:52
of directors. They desperately need this capital
2:55
raised to succeed, whether it's to fund a new
2:58
project or, you know, pay down debt. And the
3:01
window for a rights offering is incredibly short.
3:04
It's typically just Two or three weeks. Wow,
3:07
that is short. Yeah. So if they offered you these
3:09
new shares at today's exact market price and
3:12
the broader stock market dipped even slightly
3:15
during those two weeks. Oh, I see. The offer
3:17
would become entirely useless. Nobody would subscribe
3:20
to the rights offering because they could just
3:22
buy cheaper shares on the open market. Wait,
3:25
safety margin for who, though? Because that sounds
3:27
like a safety margin for the board of directors,
3:29
not for me. Yes. They just want to guarantee
3:32
they get their cash even if the market gets turbulent.
3:35
You've hit the nail on the head. It is absolutely
3:37
a safety net for the board. Oh, wow. OK. To understand
3:41
why it isn't a gift to you, the shareholder,
3:44
we have to look at the brutal arithmetic of what
3:47
actually happens to a company's share price when
3:50
they do this. Let's run the numbers, but let's
3:53
take our time with this because, you know, audio
3:55
math can be a nightmare. It really can be. We'll
3:57
go nice and slow. OK, you guide us through the
3:59
corporate side. And I'll act as the guinea pig
4:03
retail investor trying to figure out what happens
4:04
to my actual account. Perfect. Let's set the
4:07
stage using the crystal clear example from our
4:10
sources. Imagine a company that currently has
4:13
10 million shares outstanding. 10 million shares.
4:16
Got it. And those shares are trading on the open
4:18
market today at $20 a share. OK. So basic multiplication.
4:23
10 million shares at $20 each means the entire
4:26
company, its market cap, is worth $200 million.
4:30
Got it. 10 million shares, $20 a share, 200 million
4:35
total value. Right. On a personal level, let's
4:37
say I own 400 shares of this company. OK. Before
4:40
the mail arrives, my 400 shares at $20 are worth
4:43
$8 ,000. So I'm keeping that $8 ,000 number in
4:47
my head. Perfect. So the company announces a
4:50
rights offering. They are offering one new share
4:52
for every four shares you currently own. OK,
4:54
one for four. And they are setting that discounted
4:57
price at $16. OK, so that's the discount. Down
5:00
from 20. Exactly. Let's look at the corporate
5:02
printing press first. A one for four offer on
5:06
10 million shares means they are creating 2 .5
5:10
million brand new shares out of thin air. Right,
5:13
because 10 million divided by four is two and
5:15
a half million. Exactly. By selling those 2 .5
5:18
million shares at $16 each, the company raises
5:21
$40 million in fresh cash. OK, I'm tracking.
5:25
So they had a $200 million company. They just
5:28
deposited $40 million in fresh cash into the
5:31
corporate bank account. So the new fundamental
5:34
value of the entire company is $240 million.
5:38
That's right. But look at the share count. They
5:40
started with 10 million shares and they just
5:42
printed 2 .5 million new ones. So there are now
5:46
12 .5 million shares sharing that $240 million
5:50
pie. Oh, I see where this is going. Yeah. If
5:53
you divide that new $240 million value by the
5:56
new 12 .5 million share count, the share price
5:59
has to mathematically adjust. Right. It is no
6:02
longer $20. It drops to exactly $19 .20. Wow.
6:08
It's uh, it's like pouring water into a glass
6:10
of wine Yes, exactly the total volume in the
6:13
glass goes up because of the cash but the potency
6:17
of every single drop gets diluted. That's a great
6:20
way to think about it. So the average price comes
6:22
down to $19 .20. It's pure gravity. It's not
6:25
a market panic, not a bad earnings report, just
6:28
arithmetic. Wow. And this brings us back to your
6:31
portfolio and the inertia tax. OK. You have three
6:35
choices when that envelope arrives. All right.
6:37
Well, scenario one, I open the mail, I read it,
6:40
and I participate. OK. So I have my 400 original
6:44
shares, which means I got 400 rights in the mail.
6:46
Right. Because it's a one -for -four offer, I
6:48
use my 400 rights to buy 100 new shares at the
6:52
discounted $16 price. That cost me $1 ,600 out
6:56
of pocket. Let's look at your new reality. You
6:58
now own 500 shares total. Right. The new diluted
7:02
share price is $19 .20. Right. 500 shares multiplied
7:07
by $19 .20 equals $9 ,600. Let me check that.
7:13
I started with $8 ,000 in stock. I opened my
7:17
wallet and paid $1 ,600 in cash. That equals
7:21
$9 ,600. So my total value is $9 ,600. I didn't
7:28
make a single penny of profit from that 20 %
7:30
discount. No, you didn't. You are exactly neutral.
7:34
You maintained your percentage of the company,
7:36
but that discount was just a mirage. It perfectly
7:39
offset the dilution of the share price, dropping
7:42
from $20 down to $19 .20. Okay, scenario two.
7:46
I open the mail, but maybe I don't have $1 ,600
7:49
sitting in cash, you know? Yeah, that happens
7:52
a lot. Or maybe I'm fully allocated and just
7:55
don't want to buy more of this specific stock.
7:57
Sure. But I know enough to act. I take my 400
8:01
rights and I sell them on the open market through
8:03
my broker. Right, because those rights have intrinsic
8:06
value. Because they allow a buyer to skip the
8:08
line, right? Exactly. They allow a buyer to skip
8:10
the line and purchase a $19 .20 share for only
8:14
$16. OK. Our sources outline the exact formula
8:17
for pricing them. But keeping it simple for our
8:20
scenario, each right is worth roughly $0 .80.
8:23
OK. So you sell your 400 rights, and your brokerage
8:27
account gets credited with $320 in cash. Okay,
8:32
doing my portfolio math again, I kept my original
8:35
400 shares, but we know the gravity of the new
8:38
shares pulled the stock price down to 1920. Right.
8:42
So my stock is now worth $7 ,680. But I have
8:46
that 320 in cash from selling the rights. Add
8:49
them up, and $7 ,680 plus 320 is exactly $8 ,000.
8:54
Neutral again. Wow. You accepted the dilution,
8:58
meaning you own a slightly smaller percentage
9:00
of the total company now. Yeah. But you were
9:03
compensated in cash for taking that hit. Financially,
9:06
you are completely whole. OK. If you're listening
9:09
to this in your car or at the gym and zoning
9:11
out on the math, just hear this next part. Please
9:13
do. Because scenario three is where the blood
9:15
hits the floor. It really is. Scenario three.
9:18
I get the envelope. It looks like a boring Terms
9:21
of Service update. I toss it in the recycling
9:23
bin and I do absolutely nothing. So. The deadline
9:27
passes. Your rights expire completely worthless.
9:31
Right. Your 400 shares drop to the new diluted
9:33
price of $19 .20. Okay. Your total portfolio
9:37
value is now $7 ,680. I started with $8 ,000.
9:42
I now have $7 ,680. I lost exactly $320. It just
9:48
vanished. Wow. And you didn't lose it to a market
9:51
crash, or even to the company itself. Where did
9:53
it go? That $320 was transferred directly from
9:57
your pocket, the inattentive shareholder, into
9:59
the pockets of the attentive shareholders who
10:01
participated or bought those rights. Oh my god.
10:04
Doing nothing is a literal mechanical transfer
10:07
of wealth. That is wild. By ignoring the envelope,
10:10
I essentially subsidized everyone else's discount.
10:13
You paid the inertia tax. I paid the inertia
10:15
tax. So rights force you to act fast or you get
10:17
punished. But what happens when companies want
10:20
to hold that thread of dilution over your head
10:23
for years instead of weeks? Because that brings
10:27
us to another paper asset our sources cover,
10:30
which is warrants. Yeah, warrants are the long
10:33
game version of this. Like rights, they are issued
10:36
directly by the company. and they also grant
10:39
the holder the right to buy new shares at a specific
10:42
price. But structurally, they serve a completely
10:46
different purpose. They aren't pro rata. They
10:48
don't go out to every existing shareholder proportionally.
10:52
The sources refer to them as a sweetener. You
10:55
see this a lot in small cap companies who are
10:58
speculative resource and mining financings. A
11:00
company will offer investors a unit instead of
11:03
just a share. and that unit might be one share
11:06
of stock plus a half warrant attached to it.
11:09
Think about the signal that sends, though. The
11:11
company is admitting they couldn't raise the
11:13
capital just by selling their stock. Oh. They
11:15
had to throw in a sweetener to convince skeptical
11:18
investors to hand over their cash. Right, because
11:20
otherwise they wouldn't bite. Exactly. It tells
11:22
you that accessing capital is difficult for them.
11:25
They are paying a premium to get investors in
11:28
the door. Here's where it gets really interesting
11:30
for me, and I want to try an analogy here. Go
11:32
for it. A write is priced at a discount and expires
11:37
in a few weeks. But a warrant is usually priced
11:41
above the current market price when it's issued.
11:43
Right. And it can last for three, four, even
11:46
five years. Easily. So a warrant is basically
11:48
a coupon for a future purchase that you just
11:51
pinned to your fridge. Yeah, that's a good way
11:52
to look at it. But unlike a grocery coupon for
11:55
50 cents off paper towels, this financial coupon
11:59
actively loses value. every single day it sits
12:02
there. Let's build on that because the physics
12:04
of why it loses value is crucial. Okay. Your
12:07
paper towel coupon is worth 50 cents today and
12:10
50 cents the day before it expires because the
12:12
price of paper towels is relatively stable. Right.
12:15
But a warrants value is based on the probability
12:17
that the stock price will explode upward and
12:20
surpass that high target price. So as the years
12:23
tick by and the expiration date gets closer,
12:26
the runway for that explosive growth gets shorter
12:29
and shorter. Exactly. The financial term for
12:32
that rotting process is time decay. Time decay?
12:35
Yeah. A warrant is essentially a bet on a timeline.
12:39
They trade on exchanges under their own tickers,
12:42
totally separate from the stock. OK. And speculators
12:44
love to buy them, thinking they're getting a
12:46
highly leveraged, cheap version of the stock.
12:48
Right, because they cost less than a full share.
12:50
But because of time decay, if the actual stock
12:53
price just flatlines for two years, the warrant
12:56
bleeds value every day until it eventually expires.
13:00
Completely worthless. So the actual shareholder
13:02
whose stock went nowhere at least still owns
13:05
their equity like they still have their shares.
13:07
Yes. But the warrant holder who got ground down
13:10
by time decay is left holding zero. Time is actively
13:13
working against you the longer you hold a warrant.
13:15
So if we step back. Both rights and warrants
13:18
share one massive structural flaw if you're an
13:21
existing shareholder. They operate the printing
13:23
press, they create brand new shares, and expand
13:26
the pool. Yes, they do. But our sources point
13:28
out that people constantly confuse these company
13:33
issued instruments with options. All the time.
13:36
And apparently that confusion leads to the greatest
13:39
misunderstanding in market mechanics. It's what
13:42
we could call the great dilution distinction.
13:44
OK, I like that. It is vital to separate the
13:47
primary market, which are instruments issued
13:49
by a company, from the secondary market, which
13:51
is options traded on an exchange. So let's look
13:54
at the mechanics. With rights and warrants, when
13:57
someone exercises them, the company fires up
14:00
the printing press. They create brand new shares
14:03
out of thin air, hand them to the investor, and
14:05
absorb the cash. And because they are absorbing
14:08
cash at a set price, you know, a price usually
14:11
determined years ago in the case of a warrant,
14:14
existing shareholders are bearing the cost of
14:16
that dilution. The company is selling shares
14:19
today at yesterday's prices. Oh, wow. The sources
14:22
put it perfectly. Today's shareholders are paying
14:25
for yesterday's fundraising. That makes so much
14:27
sense. But options operate in a completely different
14:30
universe. Completely different. If I log into
14:32
my brokerage account right now and buy a call
14:35
option on a tech stock, The tech company didn't
14:38
issue that contract to me. They have absolutely
14:40
nothing to do with it. Really? Yeah. An exchange
14:43
traded option is a contract strictly between
14:46
two independent market participants. It's a side
14:49
bet between you and another investor. Okay. The
14:52
company is completely oblivious. So what does
14:55
this all mean? Like, wait, let me make sure I
14:57
have this straight. Sure. So if a massive hedge
15:00
fund exercises call options to buy one million
15:03
shares of a company at $15, the company's board
15:07
of directors doesn't even get a memo. Nope. They
15:10
might not even know it happened. They wouldn't
15:11
know. And frankly, they wouldn't care. Wow. Because
15:14
when that hedge fund exercises their call option
15:17
on a million shares, the option writer, the investor
15:20
on the other side of that specific contract,
15:23
is legally obligated to deliver one million existing
15:25
shares to the buyer. Oh, existing shares. Exactly.
15:28
They either pull those shares out of their own
15:30
portfolio or they have to go out into the open
15:32
market and buy them at whatever the current price
15:34
is to fill the contract. So no new shares are
15:38
printed? Zero. The corporate share count doesn't
15:40
change by a single digit. That's crazy. No cash
15:43
goes to the company treasury. No new shares are
15:45
created. And there is absolutely zero dilution.
15:49
The company is merely the subject of the side
15:52
bet, not a party to it. That is such a vital
15:55
distinction. The exact same Economic event, someone
15:59
buying a million shares at a set price has completely
16:03
opposite effects on my portfolio depending on
16:05
the instrument used. It really does. Because
16:06
if a venture capital firm exercises a million
16:09
warrants, the pie gets bigger and my individual
16:12
slice just got smaller. Yep. But if a hedge fund
16:14
exercises a million options, my slice of the
16:17
pie hasn't changed a millimeter. It's just existing
16:20
shares changing hands. Understanding that distinction
16:23
shifts you from being a passive victim of market
16:26
mechanics to an active participant. Knowing exactly
16:29
how these instruments dilute your slice of the
16:32
pie gives us a clear playbook for how to handle
16:35
our own portfolios. So if we know the difference
16:38
between a company printing shares and the market
16:41
just trading them, how do we actually defend
16:44
our wealth when we log into our brokerage accounts
16:46
tomorrow? We need a plan. Yeah, let's transition
16:49
from theory to practice with an action guide
16:52
based on these sources. The very first rule is
16:55
the simplest yet it's where most investors fail.
16:57
Rule one, open the envelope. Oh, yeah. Or, you
17:01
know, in today's world, read the corporate action
17:03
email. It sounds incredibly basic, but as we
17:06
proved with the inertia tax, rights offerings
17:08
have incredibly short deadlines. Very short.
17:11
The notification doesn't come with flashing red
17:13
sirens. It looks like routine legal jargon. It
17:16
really does. If you let it sit in your inbox,
17:18
the deadline passes, and you've mathematically
17:20
handed your money to a stranger. Which leads
17:22
directly to rule two, never choose inertia. Never.
17:26
We walk through the math. You have choices. If
17:29
you believe in the long -term vision of the company,
17:32
participate and protect your percentage of ownership.
17:34
Okay, but what if I don't want to? Well, if you
17:37
don't have the cash or you think the company
17:39
is in trouble... actively sell the rights on
17:41
the open market. Selling the rights is the only
17:45
way to remain mathematically neutral without
17:47
deploying more capital. Doing nothing is the
17:50
only guaranteed loss. That makes total sense.
17:54
So rule three is about taking a step back, which
17:56
is to analyze the signal. Just because a company
17:59
is offering you shares at a 20 % discount doesn't
18:02
mean you should buy them. You have to ask why
18:05
they need this cash right now. This is where
18:08
critical analysis comes in. A rights offering
18:10
is just a tool. Right. If a company is using
18:13
that tool to fund a major strategic acquisition
18:16
that will clearly grow the business, that is
18:19
a positive corporate signal. Okay, but what if
18:21
they aren't? Right. If a company is repeatedly
18:23
using heavily discounted rights offerings just
18:26
to repair a toxic balance sheet or pay off emergency
18:29
high interest debt just to keep the lights on,
18:32
the arithmetic of the offering is identical,
18:34
but the meaning behind it is a massive red flag.
18:38
It's the difference between buying a discounted
18:39
ticket to get on a rocket ship versus buying
18:42
a discounted ticket to stay on a sinking ship.
18:44
A very expensive sinking ship, yes. And finally,
18:47
rule four. Check. Deluded EPS. This is a big
18:51
one. This blew my mind a little bit because it's
18:53
so practical and takes five seconds So EPS is
18:55
earnings per share exactly Basic EPS is the reality
18:59
of the company today. It takes the profit and
19:02
divides it by the current number of shares outstanding.
19:05
But diluted EPS is the worst case scenario for
19:08
tomorrow. It calculates what would happen if
19:11
every single warrant, every convertible bond,
19:13
every employee stock option, every potential
19:16
new share out there in the wild is suddenly converted
19:19
into a real share. It is so empowering to know
19:22
that just checking the diluted EPS on Yahoo Finance
19:24
or whatever free site you use acts as an instant
19:28
alarm system. It really does. Because if a company
19:31
reports a basic EPS of $2, but their diluted
19:34
EPS is $1 .10, that massive gap tells me the
19:39
company has a mountain of hidden claims waiting
19:42
to trigger. The warrants and corporate options
19:44
are sitting out there like financial landmines
19:47
just waiting to dilute my stock. the moment the
19:51
company gets successful. If we connect this all
19:53
to the bigger picture, knowing the mechanical
19:55
plumbing of the market is your best defense.
19:58
Absolutely. The market is full of highly attentive
20:00
people who are more than happy to sweep up the
20:02
value you leave on the table. Right. So understanding
20:05
diluted EPS, recognizing the time decay of warrants,
20:09
and refusing to pay the inertia tax ensures you
20:12
keep what you've earned. So to synthesize this,
20:15
corporate mail is not junk mail. Never. Understanding
20:18
the origin of a security, whether it comes from
20:20
a company's printing press or just the secondary
20:23
market shuffling existing shares around, tells
20:25
you exactly who is footing the bill. Exactly.
20:28
And as an investor, your main job is making sure
20:31
the person footing the bill isn't you. That is
20:33
the ultimate takeaway. But before we wrap up,
20:36
there is one final, rather dark dynamic mentioned
20:39
in the deepest parts of our sources that I want
20:41
to leave everyone to mull over. Oh, OK. It involves
20:44
a specific clause that sometimes gets quietly
20:47
attached to these rights offerings called a standby
20:51
commitment. A standby commitment. What does that
20:54
mean? Sometimes when a company issues a rights
20:57
offering, a major insider, like the original
21:00
founder, the CEO, or a massive institutional
21:03
backer, they will make a formal legal agreement
21:06
with the company. They agree to act as a backstop.
21:09
They promise the board that they will personally
21:12
buy up any and all rights that the lazy retail
21:15
investors ignore and let expire. Wait, let me
21:18
think through the mechanics of that. So if thousands
21:20
of regular, everyday investors just toss that
21:23
boring envelope in the recycling bin and pay
21:25
the inertia tax, this insider gets to swoop in.
21:29
Scoop up all those expired rights and buy those
21:31
discounted shares for themselves. They do, which
21:33
raises an incredibly provocative question. Could
21:36
a struggling company theoretically use a heavily
21:39
discounted rights offering, fully expecting that
21:42
average retail investors will ignore the boring
21:45
paperwork, as a stealthy way to permanently shift
21:48
voting control and ownership directly into the
21:51
hands of a few insiders at a massive discount?
21:54
Wow. That is brilliant and mildly terrifying.
21:58
Isn't it? They send you the paperwork. Yeah.
22:00
They technically give you the fair pro rata chance
22:02
to participate. Yep. But they are banking on
22:05
human psychology. They're relying on the fact
22:08
that everyday people ignore dense mail. Exactly.
22:11
And by doing nothing, you not only lose your
22:14
$320. You literally hand over your voting power
22:18
and ownership state to the insiders. And it is
22:20
entirely legal. It is perfectly executed arithmetic,
22:23
working exactly as it was designed to work. So
22:26
the next time you get a dense microscopic legalistic
22:28
envelope from your brokerage, don't just toss
22:31
it in the recycling bin with the grocery flyers.
22:33
Please don't. Because now you know. That envelope
22:35
isn't just paper. It is your wealth, testing
22:38
you to see if you are paying attention.