Stock Warrants: Everything You Need to KnowStartup Law ResourcesVenture Capital, Financing
A stock warrant gives holders the option to buy company stock at the exercise price until the expiration date and receive newly issued stock from the company.10 min read
What Is a Stock Warrant?
A stock warrant gives holders the option to buy company stock at a fixed price, the exercise price, until the expiration date and receive newly issued stock from the company. A stock warrant is similar to its better-known cousin, the stock option. For starters, recall that a stock option is a contract between two parties and gives the stockholder the right to buy or sell stocks at a certain price and on a certain date. When you buy a warrant, you are not locked in. You still have the right to freely decide to go forward with the purchase in the future.
Similarly, a stock warrant holder also has the right, to buy a specific number of shares of stock that will be created in the future, upon exercising the warrant, called “underlying” stock. That transaction is called “exercising” the option, and it must take place before a specific date and at a predetermined price.
Warrants are not compensatory tools but are used simply to increase a company's capital and sweeten the deal for potential investors. The underlying stock is usually the issuer's common stock. Warrants are dilutive in nature, meaning it dilutes the overall value of equity in shares because the company must issue new shares upon exercising. Their appeal is that if the issuer's stock increases in price above the warrant's price, the investor can redeem the warrant, and buy the shares at the lower warrant price.
Example: Company Widget issues bonds with warrants attached. The holder gets a $500 face-value bond plus the right to purchase 50 shares of company stock at $10/share within 10 years. The $10/share is the strike price. So, if the stock rises over $10 within five years, this is a good investment.
Features of a Stock Warrant
- A warrant is exercised once the holder tells the issuer they intend to purchase the underlying stock. When a warrant is exercised, the company issues new shares of stock, so the overall number of outstanding shares will increase.
- The exercise price is fixed shortly after issuance of the bond.
- A warrant's premium means how much extra you will need to pay for the shares when purchasing through the warrant, rather than regularly (such as in an exchange or from another investor.
- Warrants give leverage. They are a method of determining how much exposure the holder has to the underlying shares by using the warrant to gauge the exposure, rather than the stocks or shares themselves.
- The conversion ratio is the number of warrants that are needed to buy or sell one stock. For example, if the conversion ratio to buy a stock is 5:1, this means the holder needs 5 warrants to purchase one share.
- Warrants have an expiration date, when the right to exercise no longer exists.
Warrants differ depending on which country you are in. For example, an American style warrant enables the holder to exercise at any time before the warrant expires, while a European style requires the holder to hold on to the warrant and exercise only at the expiration date.
How Are Stock Warrants Different From Stock Options?
Although warrants and options are similar, there are some important differences:
- When option holders exercise an option, the holder either sells or buys shares to or from an investor in the stock market. With a warrant, the holder sells or buys directly to or from the issuing company, not the investor.
- Warrants are also usually traded over-the-counter, usually by financial institutions that can settle and clear the trades, rather than on the public exchanges.
- Options usually expire in less than a year. A warrant may have a much longer period before it expires, sometimes as long as 15 years.
- Options are often used to attract and motivate employees. Warrants, on the other hand, are often used to attract investors, who get the warrants as a kind of bonus when they lend money to the company or purchase its newly-issued stock.
- Warrants do not come with voting rights or pay dividends, unlike traditional stocks. Investors are interested in warrants because they can leverage their position in a security, and exploiting opportunities if the stock moves quickly in either direction. Issuers can use them and pay lower interest rates.
- Options and warrants are treated differently for tax purposes, because the latter is not compensatory. Upon exercising the warrant, the investor would pay the purchase price for the shares but (unlike options) no tax would be due.
- Warrants are not as commonly used in the United States, but are widely used around the world, in major economies like Germany and Hong Kong.
Kinds of Warrants
Detachable and Non-Detachable
Traditionally, warrants are issued with bonds, making the deal a bit better for the buyer, as it is a better price. Holders of detachable warrants can sell the warrants without selling the bonds or stock to which they were originally attached. That means that when a warrant is attached to a bond or stock, the holder can sell the warrant but still and keep the bond or stock. This flexibility makes detached warrants much more attractive. This may be especially important when warrants are attached to preferred stock.
Sometimes, investors won't start receiving dividend payments from preferred stock as long as the stock has an attached warrant. In that case, if the warrants are detachable, holders may want to sell them and just keep the stock. Holders of non-detachable warrants can only sell the warrants when they sell the attached bonds or stock. As a note, these are sometimes also called "wedded" warrants. Naked warrants are issued without any bonds or stocks accompanying them.
These are issued by financial institutions, rather than companies, so there are not any new stocks issued when the covered warrants are exercised. The warrants are simply "covered" because the institution that issued the warrant either already owns the underlying shares, or can easily acquire them.
Call and Put Warrants
A call warrant allows the holder to buy shares from the share issuer. A put warrant allows the holder to sell shares back to the issuer. Both types specify the number of shares the holder can buy or sell as well as the price, called the “strike” or “exercise” price, at which the holder can buy or sell the shares. Both also specify that the transaction must take place on or before a certain date, which is called the “expiry” date. After the expiry date, the warrant becomes worthless.
The primary difference between a call warrant and a put warrant is that a call warrant will buy a specified number of shares from the company at a future date for a set price. A put warrant is a representation of the equity value that the buyer can sell back to the issuing company in the future for a set price.
Exercising a warrant is not the only way to make money with warrants. Investors can also buy and sell warrants, although it can be difficult and time-consuming, as they are often not listed on stock exchanges.
The minimum value of a warrant is the difference between the current value of the underlying security on the market and the warrant's strike price. This is the profit that warrant holders will receive if they exercise their warrants at the current time. Warrants that are trading on an exchange, however, may sell for a premium price greater than the minimum value if traders expect the price of the underlying security will rise in the future - just like basic supply and demand and predictions of the market. However, the premium will generally shrink as the expiration date approaches.
Why Are Stock Warrants Important?
Companies use stock warrants to attract more capital. This is crucial to start-ups. When a start-up issues bonds or shares of preferred stock, it can include warrants to make the stocks or bonds more attractive to investors. This is called “attaching” warrants to stocks or bonds.
Investors may expect companies to attach warrants to newly-issued stock and bonds. They see it as compensation for the risk they are taking in investing in a young company whose future may be hard to assess, especially if the company is relatively small.
Advantages of Stock Warrants
There are many advantages to purchasing a warrant. The first benefit is that warrant prices are lower. In contrast, the leverage and possible gains they offer is larger, often making it a good return on investment.
For example, imagine ABC company has quoted their stock prices at $2.00 per share. If an investor chose to purchase 1,000 shares, they would be able to get them for the price of $2,000. If, instead, that same investor decided to purchase an ABC call warrant, which is the equivalent of one share, at a price of $0.50, the investor could gain 4,000 shares with the same initial investment.
In general, both share and warrant price will tend to move in tandem. The difference is often seen in the gains and losses, which can vary greatly due to the cost of the initial investment.
Another example that can provide an illustration of the advantages of purchasing a stock warrant is company ABC having shares that gain $0.30 from $2.00 and close at $2.30. This would result in a gain for the investor of 20 percent. During this same time, the warrant will have a gain of $0.30 raising it 60 percent from $0.50 to $0.80.
To determine the gearing factor, you will need to divide the cost of the original share by the price of the original warrant. For example, $2.00/$0.50 = 4. This number provides the investor with the financial leverage that they have with the share of the warrant. As the number gets higher, there is a greater chance for higher capital losses and gains.
To see a real-world example, you can look at a deal made by Warren Buffet with Bank of America. In this transaction, his company Berkshire Hathaway acquired warrants for the Bank of America stock at a price of $7.14 each, which cost them roughly $5 billion.
After the deal was completed, the stock that was purchased had risen to $24.32 for each share. When the exercise of those warrants was determined, the price came in around $17 billion. In the end, this showed for a gain of $12 billion on the original investment.
Warrants can be a good investment in any kind of market. In a bull market, it can provide the investor with significant gains. In a bear market, it can provide them with some additional protection. This occurs because even as share prices drop, the lower price of the warrant will make the loss less.
Disadvantages of Stock Warrants
As with any type of investment, there are always some disadvantages as well as come risk. While the fact that the gearing and leverage of warrants can be high is sometimes an advantage, it can also work to the investor's disadvantage as well.
Let's go back to the ABC example and say that instead of a rise in the price of the share, the share drops $0.30. In this situation, the share would only see a loss of about 20 percent, but the loss on the warrant would be around 60 percent.
Additionally, the value of the share can drop to zero. This can present another disadvantage to someone who has invested in a stock warrant. If the drop to zero occurs before the warrant has been exercised, the warrant would end up with no redemption value.
The final disadvantage for a warrant holder over a stockholder is the lack of voting or dividend rights. While shareholders usually have rights to vote on the functioning of the company, a warrant holder does not. This means that they will be affected by the company policies but have no say in the decision making.
How Much Is My Warrant Worth?
First, understand some basic terminology: The strike price, also called the exercise price, is the price the warrant holder pays for the underlying stock when exercising the warrant.
When the warrant is issued, the strike price is higher than the market price of the underlying security at the time. The strike price may rise over time according to a predetermined schedule.
To determine the price, you can use multiple methods. One such method is the Black-Scholes method. But each method, no matter which one is used, demands a basic understanding of things that can influence warrant prices. First, understand that the intrinsic value of a warrant is just the difference between the strike price and the underlying stock price. So, if the stock price is above the strike price, the warrant is in-the-money and has intrinsic value. Time value refers to whether a warrant, and its underlying stock, will increase in price over time (or that it will be in-the-money), but it usually declines as it gets closer to the expiration date, called time decay. If the stock price never exceeds the strike price, it is worthless upon expiry.
Reasons to Consider Not Investing in Stock Warrants
Stock warrants can be risky investments. Holders can lose some or all of their money if the price of the underlying stock falls below the strike price, or if the warrants never make it in-the-money. Time decay is a major factor that must be considered when purchasing stock warrants as well.
Additionally, holders of warrants don't have the benefits that shareholders do. They have no voting rights, and they do not receive dividends.
Reasons to Consider Investing in Stock Warrants
The main reason to invest in stock warrants is leverage. When the price of the underlying security rises, the percentage increase in the value of the warrant is greater than the percentage increase in the value of the underlying security. Warrant holders can “control” more shares by buying warrants than by investing the same amount of money in direct share purchases.
Holding warrants is great during a bull market, when the price of the underlying security is going up. Because warrants usually take a much longer time to expire than options, they are generally less risky than options. There is a greater chance that the price of the underlying stock will rise, given a greater time span.
Stock warrants are usually valuable tools that companies use to attract investors, but there are some risks associated with issuing warrants.
For example, Chrysler issued 14.4 million warrants to the government when it was seeking government loans in the early 1980s. Chrysler stock was at a low point, as the company was near bankruptcy. The company thought there was no risk in issuing warrants with a strike price of $13 when its stock price was only $5. However, as the company recovered, the stock price soared to $30, and Chrysler lost $311 million on the deal. Although this example is highly unusual, you should consider all possible scenarios if your company is issuing warrants to attract investors.
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