Investor Warrants: A Primer on Warrants in Private & Public Stock Deals
In many of the capital deals we facilitate, investor warrants are often included as part of the consideration for doing a deal. Some issuers have wondered what said warrants are and how they operate in the context of an issuance of securities. Here we’ve tried to outlay some of the answers a bit more plainly.
What are warrants?
A warrant is a simple contract between the investor and the company, giving the investor the ability to purchase a specific amount of additional shares in the company at some future date and on specific terms. Warrants can be structured very differently and in various ways, but when it comes to raising capital through additional investor cash inflow, a warrant is typically an option to buy at a particular price at some point after the public offering takes place.
Investors are incentivized to buy more stock if the stock runs up in price because there is a protected opportunity for arbitrage. For instance, if an investor has a warrant option to purchase the company’s stock at $5 and the stock is currently trading at $15, then the investor can buy simply at $5 and immediately sell at $15, for a total net of $10 per share. It’s a way to immediately profit and it gives investors the ability to share more in the upside. This is helpful as an incentive to get investors to share in the risk/reward of a company’s success.
Often used as an alternative to acquiring common or preferred stock, a warrant is a contract to purchase stock at a specific price on or after a specific date in the future. In this way, a warrant is like an options contract in that it specifies a price and time for purchase of the shares in the future. Unlike an options contract, a warrant is issued directly by the company itself (not by any third parties) and the company typically issues new shares to complete the warrant purchase.
Warrants are typically used as “sweeteners” for investors in a deal. They have two distinct advantages for the issuer:
- The potential investor is not necessarily entitled to insider information prior to an acquisition or other capital event.
- Does not adversely impact a company’s S-corp status.
Because S-corps can only have 35 actual shareholders, warrants may be used to circumvent the loss of S-corp status if the 35 threshold has already been reached. However, certain preconditions or triggers are required to be met to prevent the exercise of warrants in the event that such exercise would trigger >35 shareholders. Public stock offerings, change of control or a sale of a substantial portion of the stock of the company could all trigger the exercise of warrants. In some instances, any of these events could also trigger an S-Corp to C-Corp conversion, thus making the warrant exercise (if the stock price is above the warrant strike price) all the more compelling.
How do warrants work?
Before, we delve into a real world example, the definition of a few key terms is likely warranted (pun intended):
1. Exercise Price. The price at which an investor or broker has the right to purchase shares in the company. This price is typically above the current share price and is sometimes referred to as the “strike price.”
2. Term of Contract. Warrants typically have a firm exercise date as well as an expiration date. The exercise date assumes the price at the time the warrants are issued will be below the exercise price. Otherwise, there is no incentive on the part of the investor or broker to purchase the stock.
3. Warrant Transfer Restrictions. Warrants will often hold restrictive covenants as to their transfer. This is especially true for private deals where issuers are more likely to distrust outsiders and would like to have control close to the chest.
4. Rights. Existing shareholders may hold rights that are tied to theirs or other warrants that allow them the options to purchase shares in the future so as to ensure their percentage ownership in the corporation remains constant. While similar to warrants, rights differ somewhat and they may impact the decision(s) of those who hold warrants.
Perhaps, the best way to explain warrants is to perform a simple real-world example. An investor may hold warrants in XYZ, Inc., a privately-held company. The current private price for the stock is $3/share and the warrant exercise price is $5/share with a term of five years. That is, if the price per share increases above $5 at some point in the next five years (which in this case would occur if the company had another capital event or equity infusion), then the warrant holder could elect to purchase their allotment of warrants at $5. If the market price is above $5, an even larger boon for the investor exists as an immediate arbitrage opportunity can be played wherein the investor purchases for $5/share and sells (assuming there is a somewhat liquid, secondary private market for the shares) at the higher amount. This is, of course, less common in private deals, but the example still holds true.
Such a private stock scenario does have a few downsides:
1. The warrants must be purchased. Further cash must be infused into the company.
2. Once purchased, if the private stock is illiquid, they can be difficult or even impossible to unload (sell), even if they are a “good deal” for the investor.
Raising Public Market Capital with Investor Warrants
There is no shortage of discussion on the world wide webs regarding how difficult it can be to raise capital for your business. If you’re into the new sexy of crowdfunding or even into traditional private placements, you’ll certainly always recognize the need for capital raising. Here are just a few areas in which having easy access to capital can not only help in business growth, but will help to ensure the business doesn’t die on the vine.
- Initial start-up funding for operations and new hires
- Equipment purchasing and leasing used in the production of a product or the facilitating of a service
- Bolstering inventories (both raw and finished)
- Financing of growing receivables
- Expansion–sometimes regional–of ongoing operations
- Administrative support, including management assistance and central-office build out
- Research and development of existing products, market and growth opportunities
- Exhaustion and retirement of corporate debt
- Increase market share through sales and market expenses
- Increase influence, growth and market share through mergers & acquisitions
The objective of raising capital is to facilitate many of the aforementioned necessary components of a business. However, as companies morph–and many a company will greatly morph away from their original plan–the need for adjustments and further, on-going capital will be necessary.
One of the greatest benefits of going public is the ability to tap the public markets for funding more regularly. A perfect scenario of a company who is not ready to go public is one that only requires a single financing event. Perhaps they only need capital for the purchase of some real estate or equipment. When this is the case, a public offering is likely not the most effective option. Going and being publicly-traded most benefits companies that need on-going and regular financing.
We often receive inquiries from private businesses that want to go through some of the expense of going public, but who may need to be public for just one capital raise. This is often not the most efficient option for any company. If a company doesn’t need stock as a bargaining chip, public valuation accretion or the option to raise follow-on financing through PIPEs, then being public may have too much cost to the private company.
How is the Money Raised?
The best way to paint a good picture on how money is raised through a public offering using investor warrants is to paint a real life example of a creatively-structured deal using this unique contract.
In a typical microcap/reverse merger deal, a number of small investors would purchase a few thousand shares at between $0.10 and $0.25 per share. Each share would include four to five warrants at somewhere around $0.50. This means that for each share of stock originally purchased by the investor, they might have the right to purchase another five shares at the warrant price of $0.50 once the stock reaches the $0.50 threshold.
Let’s get a bit more specific. Let’s say for simplicity, we have 100 investors each of whom purchase an initial 50,000 shares at $0.20 each. Each initial share has five warrants at $0.50. This means that for each of the initial 50,000 shares, another 250,000 shares can be purchased at $0.50 at some point in the future. For simplicity’s sake, let’s say all of the 100 investors determine to exercise their warrants when the stock price reaches $1. When this occurs, $0.50 of each warrant flows to the company as a “capital raise,” while the other $0.50 of the $1 is given to the investor as the warrant arbitrage.
Capital Flowing to the Company: 100 investors x 250,000 shares x $0.50 per share = $12,500,000
Capital Flowing to Investors: 250,000 shares x $0.50 per share = $125,000
Assuming the investors also sold their original 50,000 shares at $1, then their total return would equal $175,000.
This $175,000 returned to investors came from an original investment of $10,000 (50,000 shares x $0.20 per share). That’s a 17.5x return in a very short period of time.
While this is a fictitious example, it helps to paint a picture of how investor warrants can be used to effectively raise capital in a public offering. This example also assumes a fairly large amount of public float, especially for a small/microcap company.
Because so many of the moving parts here are reliant on one another, there are no guarantees on how well an offering with warrants will shake-out. One can only prepare and structure properly, hoping that the legal promotion of the offering will result in enough financing to sustain the business in it’s growth plans. The ultimate success of the warrant depends on the structure of the deal, the success of a promotion campaign and the price the stock reaches before each investor intends to exercise his/her warrants.
Conclusion
Warrants can be a powerful incentive tool for bringing in more investors who may truly see the upside potential in the company. They can also be a protective mechanism for companies who may have already reached their S-Corp shareholder limit, but who still would like to bring-in greater investor dollars.
- Covid-19 Impact on US Private Capital Raising Activity in 2020 - May 27, 2021
- Healthcare 2021: Trends, M&A & Valuations - May 19, 2021
- 2021 Outlook on Media & Telecom M&A Transactions - May 12, 2021
