A stock warrant is a security that gives the holder the right, but not the obligation, to purchase shares of common stock at a specified price on the warrant expiration date. Companies typically issue warrants to raise capital or to incentivize employees. In this post, we’ll take a closer look at stock warrants, including how they work and some of their pros and cons.
What is a Stock Warrant?
A stock warrant is a security that entitles the holder to buy a set number of shares at a specified price on the date the warrant expires. Companies typically issue warrants as a sweetener alongside a bond issue or preferred stock offering.
Warrants are similar to stock options in that they give the holder the right to buy shares of stock at a set price. The key difference is that warrants are issued by the company itself, while call options are traded between investors on an options exchange.
How Stock Warrants Work
Stock warrants give investors the right to buy shares of common stock at a set price at a fixed maturity date. For example, Company XYZ issues 100,000 warrants with an exercise price of $10 per share and a term of five years. This means warrant holders have the right to purchase up to 100,000 shares of Company XYZ’s common stock at $10 per share in five years on the expiration date.
Warrants are often issued alongside an initial public offering (IPO) or secondary offering as a way to raise additional capital. They can also be used as an employee incentive; for example, a company may grant warrants to new hires that vest over several years. Stock warrants can also be sold separately from the underlying security in what is known as a secondary market transaction.
Stock Warrants vs. Stock Options
Stock warrants differ from options in the way they are traded, who receives the revenues, flexibility, liquidity, and how they are exercised.
- Warrants are issued by a company directly to investors, options trade on exchanges between investors.
- Revenue from the sale of warrants benefits the company’s balance sheet, options revenue goes to the investor selling the options.
- Warrants can only be sold when the investment reaches maturity, options can be sold anytime before expiration
- Warrants are long-dated with expirations typically from 2 to 10 years; options have daily, weekly, and monthly expiry dates.
- Options are much more flexible and liquid than warrants as they trade on open exchanges.
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The 5 Pros of Stock Warrants
Stock warrants offer investors several potential benefits, including the following:
- Warrants are often “attached” to other securities. This means that they typically come with a bond or preferred stock purchase. Investors often view warrants as a “sweetener” on these deals since they offer the potential for additional upside beyond the coupon payments or dividends associated with the underlying security.
- Leverage – Warrants provide investors with greater leverage than if they were to simply purchase shares of common stock. This is because warrants allow investors to control a larger number of shares for a relatively small investment.
- Flexibility – Warrants offer investors less flexibility than option contracts because they can only be exercised at the expiration date. Options contracts, such as call options, can only be exercised at any time before expiration.
- Warrants tend to be very long-dated. They may not expire for 5, 10, or even 20 years. This means that investors can effectively “buy and hold” warrants for extended periods without worrying about expiration dates, unlike with options contracts.
- Cheap – Warrants generally trade at a significant discount to the underlying security, which gives investors the opportunity to purchase shares at a lower price than they could get in the open market.
The 4 Cons of Stock Warrants
However, there are also some potential drawbacks associated with investing in warrants, which include the following:
- Illiquidity – Warrants tend to be quite illiquid, meaning that it can be difficult to find buyers when you want to sell and vice versa. This lack of liquidity can make it difficult for investors to exit their position when they want or need to.
- Time Decay – Like all options contracts, warrants are subject to time decay, meaning their value declines as the expiration date approaches and eventually becomes worthless if it expires out-of-the-money (OTM).
- By their very nature, warrants are often attached to other securities. This means that investors may be forced to buy an undesirable security to get access to the warrant. For example, an investor who wants exposure to a warrant on XYZ Company’s stock may be forced to purchase the company’s bonds in order to get it.
- Because they are long-dated securities, warrants may trade at a significant premium to their intrinsic value.. In other words, it may take many years for the underlying stock price to appreciate enough to make the warrant profitable. For impatient investors, this may not be an ideal situation.
Examples of Stock Warrants
Below are two examples of real-world companies with outstanding warrants:
XYZ Company has 5 million shares outstanding and 500,000 warrants outstanding with an exercise price of $10 per share and a five-year term. Assume that each warrant entitles the holder to purchase one share of common stock.
Based on these assumptions, each warrant would have an intrinsic value of $5 [(current market price per share – exercise price per share) x number of shares per warrant]. However, because there is significant time value remaining on the warrant (five years), it is likely trading at a much higher price than its intrinsic value—perhaps $7 or $8 per share.
ABC Company also has outstanding warrants—in this case, 1 million with an exercise price of $15 per share and a ten-year term . . .
Based on these assumptions, each warrant would have an intrinsic value of $5 [(current market price per share – exercise price per share) x number of shares per warrant]. However, because there is significant time value remaining on the warrant (ten years), it is likely trading at a much higher price than its intrinsic value—perhaps $7 or 8 per share.”
Conclusion
Stock warrants offer investors several potential benefits, including leverage and low prices. However, some potential drawbacks are associated with investing in warrants, such as illiquidity and time decay.
Investors should carefully consider both the pros and cons of investing in stock warrants before making any decisions. While warrants do offer some advantages over other types of securities—such as being attached to other securities and having long expiration dates—they also come with some notable disadvantages (e.g., trading at premium prices). As always, it is important to do your research before making any investment decisions.”
