A warrant is a financial instrument that provides the holder of the warrant the right, not the obligation, to buy a company’s stock in the future at a predetermined price.
Employee stock options and stock warrants are similar in that each gives their holder the option to buy a share of stock during a future period at a set (exercise or strike) price. Warrants and employee stock options differ from the rights issue, however, in that they may be given to investors who are not already shareholders since they are not based on the number of shares already held as rights are.
Employee stock options are often distributed to employees as a form of compensation. At the same time, warrants may be attached to debt instruments such as a bond and sold with the bond.
The warrant entitles the holder to a certain number of underlying company shares at a predefined price. This is like a call option to buy the shares. The primary difference is that the warrants are issued by and exercisable on the company, which will issue new shares if exercised. Options are held by investors and relate to shares already in issue; their exercise does not result in new shares being issued. Warrants have similar characteristics to call options in terms of their volatility, risk, and how they are value.
Why Do Companies Issue Warrants?
The stock warrant represents a potential capital source in the future when the organization requires raising more capital without giving out any other stock or bond. In addition, companies can issue stock warrants as a capitalization alternative when they head toward bankruptcy. Giving out stock warrants offers the company a future capital source.
Moreover, the company may issue such a warrant to protect goodwill from the company’s shareholders. It will be far easier to persuade these shareholders to pay Rs 10 for every stock warrant than to buy extra company shares at Rs 100. However, one should utilize stock warrants carefully owing to the quick losses or gains they create.
The company will receive any new capital when the warrants or employee stock options are exercised. The issuance of a warrant (unless it is attached to a bond) does not bring new capital to the firm. The same is true of an employee stock option – it only brings in the capital (in the amount of the exercise price) when exercised.
Example: Issuing Warrants Could be Risky
Stock warrants are usually valuable tools companies use to attract investors, but some risks are associated with issuing warrants.
In the mid-1980s, Chrysler corporation issued 14.4 million warrants to the government when it sought government loans. Chrysler’s stock was low 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.
Types of Warrants and Options
When a warrant attached to a bond gives the owner the option to buy stock in the company, it may enable the issuing company to reduce the cost of the bond (i.e., the interest rate) because a bondholder with a warrant is also receiving the value of the warrant in addition to the bond itself.
Usually, warrants included with bonds are “detachable warrants,” meaning that the holder may immediately separate the two securities and choose to hold or sell each independently.
Therefore, the selling price of the “bond-with-warrants” must be allocated between the bond itself and the attached warrant(s). Since it is relatively easy to determine the price of the bond itself (the present value of the future cash flows), the value of the detachable warrants is initially equal to the purchase price of the bond-with–warrants package, less the value of the bond.
A “non-detachable warrant” has no value unless it is attached to the bond. Therefore, in a non-detachable warrant, none of the sales prices is allocated to the non-detachable warrant because it may not exist without the bond.
To complete or sweeten a business deal, standalone warrants are sometimes given to business partners. These again allow the holder to buy stock in the company offering the warrant at a specified price for a specified period.
Employee Stock Options (ESOPs)
Many companies give employees stock options as compensation (or bonuses). These options increase in value as the stock price of the company rises. Therefore, they can provide management a powerful incentive to work to create substantial increases in the stock price, which benefits all shareholders.
Options (Derivative Contracts)
In addition to stock options granted to employees by their employers, there is a very active options market. In these markets, individual or institutional investors grant other investors the right to buy (calls) or sell (puts) stock in a company at a specified price for a specified period. However, because the company is not involved in these “traded options contracts,” no capital is raised by the company. Instead, these transactions are simply a way for two investors to buy and sell shares or stock to each other.
Features of Stock Warrants
The following are some of the essential features of stock warrants you ought to be familiar with.
All stock warrants come with an expiration date. You can see this date on the contract. However, stock warrants may let the recipient execute the warrant any time before and even on the expiration date.
An organization will announce a warrant strike after issuing a new bond offering.
This is the number of stock warrants required to sell or purchase a single stock. For instance, if the conversion ratio to buy a particular stock is 7:1, what this means is that the holder requires seven warrants to buy a single share.
In all stock warrant deals, recipients can inform the organization when they will exercise their right to buy the stock. Once the private establishment that offered the stock warrant receives that buying notice, it will issue new shares of stock to enable the trading of more shares of its stock. As a result, this will boost the total stock shares of the company, which can lower the stock price.
Exercising Stock Warrants
Let’s understand when a stock warrant is exercised:-
- Holders of a stock warrant might select to exercise the said warrant if the stock’s current price is more than the warrant’s strike price.
- If the current price of the stock is lower than the strike price, it does not make too much sense to exercise the option. That is because it is more economical to purchase stock from the market.
Let us take an example to understand this better. For instance, a stock warrant’s strike is Rs 30, and the stock trades at Rs 20. In this case, it is not wise to exercise the right to purchase stock at Rs 30 when you can buy it at Rs 20.
On the flip side, if the stock is currently trading at Rs 40, and the stock warrant’s strike is Rs 30, it is advantageous to exercise the stock warrant. However, simply because the current price of the stock is more than the strike price does not mean it is necessary to exercise the warrant. If there is adequate time until the stock warrant expires, clinging to the warrant might be even more profitable!
In the latter case, if, over the next couple of months, the stock climbs to Rs 70, the stock warrant has become more invaluable. The stock is trading at Rs 70, and the warrant holder has the right to purchase at Rs 40 (and can instantly sell these shares for Rs 70).
Secondary Market for Warrants
Sometimes, the issuer will try to establish a market for the warrant and register it with a listed exchange. In this case, the price can be obtained from a broker. But often, warrants are privately held or not registered, which makes their prices less obvious. Unregistered warrant transactions can still be facilitated between accredited parties, and several secondary markets have been formed to provide liquidity for these investments. Warrants are longer-dated options traded in the ‘Over The Counter market (OTC).
Advantages and Disadvantages of Issuing Warrants
Advantages of Warrants to a Company
- I am raising immediate cash without the finance needed for dividend payments for new shares.
- The increasing attraction of a debt issue. Many warrants are attached to a debt issue, giving debt investors the added interest of an equity kicker. This will translate into lower required yields on the debt, meaning that the initial financial burden on the company is lower.
- After the debt is issued, the warrants are usually detached from the debt and traded separately in the secondary marketplace. (There is a secondary market for more attractive and liquid warrants.)
- If the share price drops, then warrants issued are unlikely to be exercised. This means that the company will have received money on the issue of the warrants, but it will not pay for issuing any new shares.
Disadvantages to the Company
If and when the warrant is exercised:
- The company issues new shares, potentially at a significant discount to the prevalent share price.
- Required dividend payments in total may increase dramatically if the share price is not to be detrimentally affected.
Advantages to Investors
- Investment in a company’s shares that are a cheaper alternative to buying the share itself, similar to a call option.
- Way of securing an income yield while keeping available high equity performance through buying debt plus warrants from the company. Similar to the principle of buying a convertible debt issue.
Disadvantages to Investors
- Percentage losses could be extreme if the share underperforms.
- Risk of a company takeover. If the company is taken over, the exercise date of the warrants will probably be accelerated to the takeover date. This will destroy any time value in the warrant, meaning that an investor could suffer a significant loss. If the warrant is out-of-the-money, having just been issued, it could become worthless.
Conclusion: Warrants are Useful to both Investors and Companies
The best strategy for exercising warrants is to wait until you are sure the company is totally out of the woods and the warrants will definitely be worth something. Then, once you have made that decision, exercise them as soon as possible.
From a company viewpoint, warrants could be helpful as they look to attract investors and raise capital early in the life of your company. Raising money as a startup is inherently more complex than raising capital as a mature company. An unproven company is viewed as a risky investment. Warrants can go a long way toward enticing people to invest in your company. For example, suppose an interested investor is worried their ownership might be diluted during future funding rounds. In that case, a startup company can offer the investor warrants they can exercise the next time they look for funding. That way, a startup receives capital from that investor and can feel more secure in their investment.