A "warrant" is a security based on an underlying security which assigns the owner the right, but not the obligation, to purchase additional shares of the underlying security at a predetermined price for a preset period of time. The purchaser of the warrant typically gains that right at a lower cost than would be incurred with the outright purchase of the common stock of a company.
Characteristics of Warrants
To better understand what a warrant is, common stock must be understood first. Common stock is actual ownership of a publicly traded company. It is equity. Its value is determined each time it trades in the open (stock) market. The holder of common stock has an actual stake in the profit (or loss) of the company. Warrants simply give the holder a right to purchase the common stock at a later time, but warrants also have a finite lifetime and will expire. They have no equity stake in a company, but they do have value.
Risk Factors of Warrants
Any stock will carry some amount of risk, but the risk factors of warrants differ. Common stock value is directly tied to the profitability of the company. As the worth of a company increases, the value of the equity--and stock--increases. The opposite is also true; if worth declines, the value of the stock declines. Since warrants are not equity, they cannot directly participate in the profitability of the company. However, their value is dependent on the price of the stock and the term remaining until expiration. Warrants are typically used to entice potential financial commitment from investors. They are often initially attached to a company-issued stock or bond offering when a company has an unusual need to raise capital. That unusual need is an additional risk factor.
While this is a simple illustration, it is representative of warrant offerings.
Company ABC needs to raise money and is about to make an initial public offering (IPO). It has filed to offer three million shares of stock at $10. The company is unsure if it can sell all shares, so it attaches one warrant to each share at no additional cost to make the offering more attractive. This warrant will permit the purchaser of this initial offering to buy one additional share at the same initial price within ten years--in this example--of the IPO.
First, the new company may fail, in which case the stock and warrant are worthless.
Second, the new company may succeed, but not as much as anticipated. If the common stock does not appreciate above $10 per share at the expiration of the warrants, the warrants have become worthless, and the stock is worth the current market value.
Third, the company is very successful, and its share price for the common stock rises to $40, for example. Within the first ten years, the investor who purchased the IPO can exercise his warrants and take possession of the additional shares with a gain in value.
Occasionally, warrants have no secondary market in which to make a transaction. However, warrants can also be registered by the issuer and traded on an exchange. In this event, the value of the warrant can be tracked through quote sources online or in print, or through a broker. The security usually has the symbol of the underlying stock with an additional "w." or "wt." attached to it.
Warrants are similar to options with respect to rights of ownership or transfer of risk. They can be a useful tool, but it is important to realize that they have no inherent value unless converted to common stock.
As always, seek the advice of an investment professional.
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