TL;DR
A Warrant is a financial derivative that gives the holder the right to buy a company’s stock at a specific price, known as the exercise price or strike price, before the warrant expires.
Warrants are typically issued by the company and are often attached to other securities, such as bonds or preferred stock, as part of a financing deal. They are similar to stock options but differ in their issuance, terms, and purpose.
Unlike shares of stock, warrants do not represent immediate ownership in the company. Instead, they represent the right to purchase ownership (shares) in the future at a fixed price.
If the company’s stock price rises above the strike price before the warrant expires, the holder can exercise the warrant to buy shares at the lower price, potentially profiting from the difference.
How Do Warrants Work?
Warrants work by granting the holder the right to purchase a set number of shares at a predetermined price within a specified time frame.
Here’s a breakdown of how warrants function:
1. Issuance
Warrants are usually issued by the company during a financing round or as part of a strategic partnership.
They may be attached to other securities, such as bonds or preferred stock, as a “sweetener” to make the investment more attractive. Warrants can also be issued directly to employees or advisors as part of their compensation.
2. Strike Price
The strike price (also known as the exercise price) is the price at which the warrant holder can buy shares of the company.
This price is usually set when the warrant is issued and is often higher than the current market price of the company’s stock at the time of issuance. The strike price is fixed for the duration of the warrant’s life.
3. Expiration Date
Warrants come with an expiration date, which is the deadline by which the holder must exercise their right to purchase the shares. If the warrant is not exercised before the expiration date, it becomes worthless.
The expiration period can vary, but it is often several years, giving the warrant holder ample time to wait for the company’s stock price to increase.
4. Exercising the Warrant
To exercise a warrant, the holder pays the strike price to the company in exchange for the shares.
If the current market price of the company’s stock is higher than the strike price, the warrant holder can buy the shares at the lower strike price, then either sell them at the market price for a profit or hold onto them for future appreciation.
- Example: Suppose a startup issues a warrant with a strike price of $5 per share. Several years later, the company’s stock is trading at $10 per share. The warrant holder can exercise their warrant, buy the shares at $5, and potentially sell them at $10, earning a $5 profit per share.
5. Cashless Exercise
Some warrants allow for cashless exercise, meaning that the warrant holder doesn’t need to pay cash to purchase the shares.
Instead, they receive a reduced number of shares based on the difference between the market price and the strike price. This is useful for holders who may not want to pay the full strike price in cash.
- Example: If a warrant holder has the right to purchase 1,000 shares at a strike price of $5 when the market price is $10, a cashless exercise might allow them to receive 500 shares (reflecting the value of the profit) without paying the strike price in cash.
Types of Warrants
There are two main types of warrants: Equity Warrants and Covered Warrants. While both grant the right to purchase shares, they differ in how they are issued and the purpose they serve.
1. Equity Warrants
Equity warrants are issued directly by the company and give the holder the right to purchase newly issued shares from the company.
These are the most common type of warrant used in startup financing, and they result in the issuance of new stock, diluting the ownership of existing shareholders.
- Example: A startup may issue equity warrants to an investor in exchange for capital, allowing the investor to buy additional shares at a future date if the company grows and its stock price increases.
2. Covered Warrants
Covered warrants are issued by a third party, such as a financial institution, rather than the company itself. They grant the right to buy shares that are already in circulation, so they do not result in the creation of new shares.
Covered warrants are more commonly used in public markets rather than startups.
Example of Warrants in Action
Let’s say a startup, VC Scoop, raises $2 million in a Series A funding round and issues 100,000 warrants with a strike price of $10 per share.
If VC Scoop’s stock price rises to $20 per share over the next three years, the warrant holders can exercise their right to purchase shares at $10. If they choose to do so, they can buy shares at half the market price, potentially selling them at a profit.
Conclusion
Warrants are a valuable financial tool for both startups and investors, offering a way to raise capital, incentivize key stakeholders, and provide future upside potential.
Interested in learning more VC related terms? Head over to our VC glossary!