30 Jan A Primer on Warrants
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?
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.
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.