What are Stock Warrants? How do they Work?

Stock Warrants from Kinder Morgan

Sample Stock Warrant

Often you might come across stock warrants and you might have wondered what does it mean. Even if you are not interested in buying the warrants, it is important to know if the company that you are interested in buying the stock in also has outstanding warrants, as the warrants can have disproportionate effect on the returns you may be able to realize from the stock itself. To understand why this is the case, it is critical to understand what is a stock warrant and how it works. There are similarities between warrants and options but they also differ in some key respects

Difference between Stock Warrants and Options

If you have stock options awarded to you through your employer, you have the basic idea of how these options work. If you invest in publicly traded options then you have even better idea of how the options work. Warrants are similar to the options, but with one critical difference.

Just like an option, a stock warrant is issued with a “strike price” and an expiration date. The strike price is the price at which the warrant becomes exercisable or “in the money”. Both the warrants and the options eventually expire, if they are not exercised by a certain date.

The Key Difference Between Warrants and Options

Publicly traded options are created by the exchanges and are backed by the stock that already trades in the secondary market (the stock that is already issued that most of us buy and sell – as opposed to the primary market stock issue such as an IPO). When a Call Option is exercised, for example, the required amount of stock from the secondary market is purchased at the strike price.

Stock warrants on the other hand are issued directly by the company and they may trade on the exchanges or over the counter. When a warrant is exercised, the stock that is purchased upon exercising the warrants needs to be issued new by the company. These are not the shares that trade on the secondary market.

So you can see, exercising an option has no effect on the total number of common stock shares outstanding, whereas exercising a warrant increases the total number of common stock shares outstanding.

Stock warrants can also be long term, expiring far in the future while the options are typically short term instruments, expiring within the year (LEAPS are long term options but they are typically only available for a few selected stocks).

If you own common stock in a company that also has warrants outstanding, any exercise of the warrants will increase the number of outstanding shares thereby diluting the existing shareholders. This dilution is more pronounced when warrants are exercised, compared to say, the company issuing new shares on a follow on offering since any follow on offering is typically done close to the market price of the shares, while the exercise of the warrants are typically done below the market price of the shares.

Example of a Warrant

Consider a hypothetical warrant with a strike price of $25 and an expiration date of June 1, 2020. Let’s say the shares of the company currently trade at $5/share. We will take 3 dates with hypothetical stock prices and review how the warrants will behave on those dates and prices.

Situation 1: Today, Stock Price = $5/share

Since the stock price today is $5 and the warrants have a strike price of $25, exercising the warrants today does not make sense. It will force the warrant holder to purchase new stock at $25/share while the stock can just be bought in the secondary market at $5/share. Therefore, the warrants will not be exercised. The warrants will also have very little value because they are so far “out of money”.

The warrants will still have some value. This value comes from the fact that the warrant does not expire for another 8 years and it is likely that the stock price might exceed $25/share at some point during the next 8 years. Just like options, the value of the warrants can be calculated by using the Black Scholes method. Let’s assume, for the sake of the example, that the value of the warrants is $0.25

Situation 2: June 1 2016, Stock Price = $30/share

If the stock price has risen to $30/share by June 1, 2016 the value of the warrants is at least $5. This is because the warrant holders are now able to exercise the warrants, buy the stock at $25 and sell it back in the market at $30 for a $5 profit. Knowing this the market moves to bid up the price of the warrant until the possibility of profiting by just buying the warrant and exercising it right away disappears.

Note that if an investor buys the warrant on June 1 2016, and immediately flips it by exercising it and selling the resulting stock, he will not make any profit. In fact, he may end up with a loss since the price of the warrant is likely to be more than $5 (there are 4 more years remaining before the warrants expire and the probability that the stock price might move higher than $30 in that time gives the warrant additional value).

However, if the investor bought the warrants 4 years ago and paid very little for it, this is a great time to sell the warrants or exercise them. In this scenario, the investor in the warrants may end up with a profit of $5 – $0.25 = $4.75 or 1900%. The stock only went up by $30 – $5 = $25 or 500%.

Situation 3: June 1 2020, Stock Price = $25 or less

The warrants will expire worthless since there is no possibility of profiting by exercising the warrants. Note that the stock may have fallen only 17% since June 1, 2016 but the value of the warrants have declined by 100%.

As this example shows, the Warrants are highly leveraged and magnify the gains or losses on the stock. Therefore they should be used with care and unless you are a professional options trader and are comfortable with the risk, you should keep your exposure to the warrants to a small part of your portfolio.

That being said, warrants do have a role to play in an investor’s portfolio. They can be a way of controlling larger amount of stock with using a less capital than if you buy the stock directly. They can also be used for hedging purposes, similar to options.

And sometimes, the stock may not be undervalued but the stock warrants may be since warrants are not as popular with investors as the common stock. In those situations, it may offer the possibility of a risk free arbitrage.

Here is a real life example of a stock warrant that we bought and sold over the course of 1 year. These warrants were originally issued by Real Opportunity Investments Corp as an incentive for the investors to purchase their stock. The warrants are now nearing expiration, set in Oct 2014.

Comments

  1. Brent says

    So I was issued x number of warrants of a gold mine as a buy out offer. The current price of the stock is $15 and change, however the warrant is exercise date is May 2017 at $29 and change. I believe the stock will never get to that price level, so basically the company didn’t give me anything as I am sure the warrants will just expire at the due date…. correct ?

    • says

      Brent, the warrants will still have value since the expiry date is in the future and there is some probability (however small) that the stock might get up to $29 and above before the expiry date. The value though will be very little today if the stock price is so much under the exercise price. If the stock price does not reach $29, then the warrants will expire on the due date and if you hold it until then than your value will be zero.

      Depending on what the warrant value is (you can try and find the ticker for the warrant to find out what they are trading at) and how many you have, it may not even be worthwhile to sell them as commissions might eat up a big part of your proceeds. So in that sense, it may be advisable to just hold on on the off chance that the stock might appreciate enough to make this worthwhile. There is still about 4 years left, so why not!

  2. Amaigus says

    Great, intelligently written article. I knew they were like options in some way, so you explained it perfectly by making a direct comparison.

    What is strange is the motivation for issuing them. Seems like a weak way to raise money. Take in a small premium in exchange for lots of dilution later. At least Employee stock options motivate the employee, making the giveaway more worthwhile. On the other hand, the company raises cash early from the process of diluting at higher prices, and implicitly doing a buy back at lower prices (at expiration). But why not do that with the real thing, dealing with real money.

    It doesn’t make me want to hold stock (or warrants) in a company that issues warrants. What is the management saying about their optimism?

    • says

      Thank you! Warrants do reflect the weak position company is in when they are raising money. Most of the time, they are thrown in as a sweetener to make a deal (private stock offering or a bond issue or just simple loans) go through and are almost always privately negotiated. Regular options are traded on public options exchanges whereas warrants can be very illiquid over the counter and may not be standardized. For example, when Buffett came to the aid of Goldman Sachs a few years ago, warrants were the carrot that made the deal go through.

      Dilution is a valid concern for the stock if there are warrants outstanding. Warrants themselves may actually make sense as an investment depending on the current stock price, business fundamentals and expiration date. Some of these warrants may have been issued so long ago that the business fundamentals may have materially changed by now so do take that into account.

  3. Dennis Brower says

    I am being offered stock and warrants as settlement in a bankruptcy case. I am told I have to pay US tax on the stock and the warrant before the stock can be sent to me. Why pay income tax on something that may be worth $0?

    • says

      Dennis,

      You should be able to take a capital loss later when the warrant (and possibly stock) turn out to be worthless. Taxation is outside my expertise but be sure to keep the paperwork to help you figure out the cost basis (the current worth of the stock and the warrants, probably through an appraisal if this is being done under a legal process). Also, if the stock and the warrants are being offered to you in lieu of your original ownership stake in an asset, you might be able to take a capital loss right away if the value of what is being offered to you is less than your initial investment. A competent tax advisor should know the exact rules.

      Regards,
      Shailesh

    • says

      Amar,

      Warrants listed on NYSE can be found at

      http://www.nyse.com/about/listed/lc_ny_issuetype_1076458359968.html?ListedComp=All

      for Nasdaq and OTC, you will have to print out (download) a list of all stocks or issues trading on those exchanges and then manually filter for warrants. Typically warrant symbols end in W or WS

      Some sites have tried to compile a database of currently active stock warrants. These include stockwarrants.com and commonstockwarrants.com. However, I cannot vouch for their services and accuracy.

      Also, I have not read Wall Street Journal recently (I know, blasphemy!) but I think they do have a listing of commonly traded stock warrants in there.

      Regards,
      Shailesh

  4. says

    Shailesh,

    As a startup issuing warrants to a founder as part of an acquisition, my client wants to issue said warrants without an expiration date. Can that be done, legally? Thanks.

    • says

      Bob,

      Perpetual warrants are possible and there are no legal restrictions around these. They are not very common though but I see no reason why they cannot be issued. Even if they do not have an expiration date, they may de-facto expire when the rest of the terms of the warrants are met.

      Regards,
      Shailesh

  5. Maxwell says

    Thank you for the breakdown. However, I am still a little confused about the process. Here is the scenario I am in…

    On October 18, 2013, I purchased 3,973 warrants at a price of $1.18 ea. With an exercise price of $5.00 a share and an expiration of June 2018.

    As of Nov 1, 2013, the stock itself is at $3.69 and the warrant price is $1.38

    Lets say on Nov 15, 2013, the stock went to $14 a share and I decided to exercise the warrant. Here is where I am confused, when I exercise the warrant do I have to pay additional $5 for each share even though I purchased the warrant at $1.18?

    Any help is appreciated. Thank you in advance!

    • says

      Maxwell,

      Yes. The warrant gives you the right to purchase the stock at $5/share. You bought this right when you paid $1.18/warrant. If the stock goes to $14 and you exercise the warrant, you will pay $5/share for each warrant exercised. Presumably, you will turn back and sell the stock at $14 and keep the difference ($7.82/share) as your profit.

      Alternatively, at the stock price of $14, the warrant itself would be valued quite a bit, closer to $9/warrant. You could just sell the warrant back into the market without going through the exercise process.

    • says

      Jen, the offering document for the warrants will have the detail. Should be a document filed with the SEC. Alternatively, most companies do mention these details in their annual reports for the outstanding warrants so that is a quick way to check.

      • jen dahl says

        Thank-You!!!! I bought ICLDW today at 2.17. It closed at $4.64. The exercise price (I think is $5). ICLD is currently at 10.10 after hours. I’m usually hold stocks for a long time. Today is the first time I have ever purchased a warrant issue.

  6. Allan Tan says

    Gaming company Leisure & Resorts World Corp. expects to raise P437.5 million in fresh funds from the issuance of preferred shares and warrants.Leisure & Resorts, based on the registration statement approved by the Securities and Exchange Commission, will issue 250 million preferred shares for P1 apiece and 12.5 million warrants at P15 per share.The buyers of preferred shares will be entitled to a dividend rate of 8.5 percent per annum.Meanwhile, the warrants will be issued to buyers of preferred shares on the fifth year from the issuance of the preferred shares.Under the plan, an investor buying 20 preferred shares will be entitled to purchase 1 warrant share at P15 apiece.  The offering period for the preferred shares will start from March 13 to 21, while the listing date is set on March 31.

    Ir, kindly explain this to me… the current price of the warrant is 0.90/share. Is it advisable to by warrant at this price?
    Thank you

    • says

      Allan, I assume the warrants are convertible to common shares even if they are being issued along with the preferred. What is the current price of the common shares and do you expect the common shares to do well in the next 5 years based on the business prospects?

      Finally, I may be misunderstanding this, but are you saying that the warrants have already been issued (since they are trading at 0.90/share) but the preferred shares will be offered in March?

      I generally do not like to buy the warrants when they are issued as it indicates a negotiating weakness on the company’s part. In a year or two, the business might be much stronger making the warrants compelling.

  7. Lorne says

    This was somewhat helpful learned lots,but a private company being taken over by another private individual in order for the sale to go threw do you have to exercise your warrents to complete the transaction,thankyou

    • says

      Hi Lorne,

      If the take over is being done as an asset purchase, then most likely the existing warrants will be nullified. Essentially, the current business is being closed and the assets are being sold. If it is done based on the equity method, it is quite possible to negotiate the treatment of the warrants and have them carry forward. Please consult a M&A attorney for better detail and things might be a little different in Canada from US.

      Should add that if the warrants are in the money (i.e, the stock/company value is worth more than the strike – not sure how this is determined in the private market) and if you are a holder of the warrant, you are better off exercising them and taking the equity in the business prior to the sale.

      Regards,
      Shailesh

  8. Anmum says

    Thanks a lot for the insight! Shailesh… Now I’m quite clear about the warrants. May I ask about premium and gearing, which I found in announcements? What are those? Are those showing significant information.

    Best regards,

  9. james morgan says

    what happen to warrants if company is bought out at a high pps do you get the stike price of the warrant or closer to the pps

    • says

      Hi James,

      Please refer to my answer to Lorne above. You are talking about a public company so the purchase method is equity. In this case, how the warrants are treated are based on the methods laid out in the offering document. If the offering document is silent on this, than it may be subject to the negotiated treatment between the acquirer and the acquired companies.

      But lets say the acquisition is not closed yet. In this case, you should be able to get the value of the warrant that is derived from the pps (assuming as you state the the pps is high and above the strike). The reason is that if you do not, you should go ahead and exercise the warrant, forcing the company to issue new stock, and then sell the stock in the market to make up the difference.

  10. Su says

    Hi Shailesh Kumar,

    So, basically a warrant can be bought and sole in the market just like a share without mandatorily be exercised? The only difference is that the warrant allow the holder to own the underlying share at the pre-defined exercising price? but the profit generated still the same whether exercise warrant or not?
    Thanks.

    • says

      Generally yes. Like any instrument, the actual price you get depends on how liquid the market for that warrant is. The commissions for selling versus exercising might also be different depending on your broker (selling is generally cheaper). Other than these transaction costs, there is no difference in whether you sell it or exercise it.

  11. Tejas Mehta says

    Can the warrants be sold without being exercised (meaining traded for a stock at strike price)? If I have warrants which I purchased at $2 couple of years ago with a strike price of $40, and today, the warrants are trading at $4 and the strike price of $40 has hit, can I just sell the warrants (as if I were to sell any common stock in the market) and make the profit of $2 per warrant? OR is it mandatory for the warrants to be exercised and traded with a stock?

    Also, can warrants be sold if the strike price does NOT hit? Let’s say the warrants are $3 and the strike price hasn’t hit, but warrants are about to expire in few months. Can I just sell the warrants for $3 per piece and still make some money although the strike price of $40 hasn’t hit?

    • says

      Hi Tejas,

      Warrants can always be sold regardless of whether the strike price is hit or not. The price you receive will of course vary based on the stock price vs strike price. If you hold the warrants in a brokerage account, the process is just like selling a stock. If you do not hold it at a broker, i.e you have physical warrants, check with your broker for the process to transfer them to your account with the broker.

      Shailesh

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