What Are Stock Warrants?
When a company needs to raise capital to cover expenses or fund expansion, sometimes it issues stock or bonds to meet its needs. Another possibility is to sell warrants to investors willing to bet on the future success of the company and the appreciation of its share price. Because of their nature, issuance of warrants is relatively rare and usually occurs in combination with other forms of capital raising. Warrants, like other similar instruments, can be traded in over-the-counter and open markets as traders speculate about their potential and intrinsic value.
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Features
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A warrant is similar to a call option in that it entitles the owner to purchase shares of a company at a fixed price, called the strike price, at some point in the future. The expiration of warrants is usually much more long term than options, however, often lasting five years or more. Also, the exchange ratio between warrants and shares is not fixed as with options contracts.
Considerations
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Like options, warrants can have either American exercise, which entitles the holder to exchange the warrants any time prior to expiration, or European exercise, which can only be effectuated at the expiration date. Clearly the American style offers more freedom to the warrant holder and makes a more attractive investment.
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Effects
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Warrants represent a somewhat risky investment. Since the strike price is almost always higher than the current share price, warrants can expire worthless if the share price never meets or exceeds the strike price. If the warrants are issued with a European style exercise, the price may rise above the strike price but dip below on the day of expiration. Only if the warrants can be exercised for less than the going market price do they yield profits for the investor.
Significance
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When a call option is exercised, the option holder exchanges a single contract for 100 already-existing shares. When a warrant is converted into stock, new shares must be issued, diluting existing shareholders. As a result, the issuance of warrants are often viewed negatively by existing shareholders. If the share price reaches the strike price of the warrants, their ownership interest will be diluted. If not, their assets will probably not appreciate significantly over the term of the warrants.
Types
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In addition to acting like a call option, some warrants function more like puts. These resemble convertible stocks or bonds in that they are redeemable at a fixed price. If the share price rises above the strike price, the warrants are less valuable than the underlying stock. If the stock price falls below the strike price, however, the owner of a put warrant can still exchange them for the higher value.
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- Photo Credit Jeremy Kemp
