What Is a Stock Warrant and How Does It Work?
If you’re already familiar with how stock options work, you should have a relatively easy time understanding stock warrants. Both are types of derivatives that allow, but do not obligate, the holder to buy or sell a company’s stock at a fixed price on or prior to a specific date.
But stock warrants are very much their own thing, with several key differences that set them apart from stock options and other equity derivatives. While it can be difficult to keep track of all these equity terms, knowing how stock warrants work can help you navigate those all-important quests of locking down financing and providing the right incentives to your investors and business partners.
In this guide, we’ll take you through the basics of stock warrants and discuss when you might consider using them as a tool. We’ll also show you how Pulley can help you add and track warrants on your company’s cap table.
- What is a stock warrant?
- Why do companies issue stock warrants?
- How do stock warrants work?
- Key terms and features of a stock warrant
- Stay on top of warrants and other securities with Pulley
What is a stock warrant?
A stock warrant is an equity derivative that allows the warrant holder to buy or sell shares of stock in the issuing company at a specified price (known as the strike price or exercise price) on or before a specified expiration date. The holder isn’t obligated to exercise a warrant, and they have the right to simply let the warrant expire if they choose not to use it to purchase a specific number of shares of the underlying stock.
But say the warrant holder does exercise a warrant. What happens then? Well, the company must issue new shares of stock equal to the number of shares in the exercised warrant. This is an important point. It means that the act of exercising a warrant can dilute the equity value of other shares by increasing the overall number of shares.
(Quick sidenote: People sometimes talk about this as a key difference between stock warrants and stock options—warrants are dilutive because they create new shares, while options aren’t. This isn’t entirely true, however. Employee stock options, i.e. the kind issued to employees as a type of equity compensation, can also be dilutive. Exchange-traded options, i.e. the kind investors buy or sell on a stock exchange, are generally not dilutive.)
So, if warrants are dilutive, what’s the appeal to companies that issue them? One big advantage in terms of fundraising is that the proceeds from an exercised warrant go directly to the issuing company and can thus be used to raise capital.
Why do companies issue stock warrants?
Though they’re somewhat common in countries throughout Europe and Asia, stock warrants aren’t wildly popular in the United States. With that said, they do have their appeal. Let’s take a look at a few reasons why a company may issue stock warrants.
To raise capital from investors
Companies typically issue stock warrants when they want to raise capital.
Warrants can be an especially effective fundraising tool in early financing rounds, where they can be used to give investors a greater incentive to purchase your stock. Since warrants tend to be pretty inexpensive relative to their underlying securities (typically shares of common stock), investors may find them to be an appealing way to invest in a potential future ownership percentage while spending less money upfront.
For its part, the issuing company raises capital at the time the warrant is sold as well as later, when (and if) it’s exercised.
To secure better lending terms from banks
A company may also use warrants as a negotiating tool when entering into lending deals with banks and other financial institutions. In some cases, adding a warrant to the terms of a debt agreement with a bank can help a company unlock better interest rates or payment terms.
A warrant issued as part of a lending deal may specify a certain number of shares of common stock that relate to the amount of the loan. Some lenders may deem the promise of future equity in your company less appealing than a higher interest rate—but some may see a warrant as an extra bit of incentive to do business with you.
To incentivize partners and (more rarely) service providers
Warrants can also be used to grease the wheels in transactions with other third-party partners or suppliers, who may find that it makes sense to purchase inexpensive warrants (and thus, the potential for future equity) in a company they’re doing business with.
We haven’t talked much about employees and other types of service providers in this guide, and there’s a reason for that. While warrants can be granted to service providers, as a general rule they are not allowed as compensation. In any case, they’re much less common than stock options and other forms of equity compensation.
How do stock warrants work?
There are a few different types of warrants out there, and each type has its own peculiarities in terms of how it works.
We should be clear up front that warrants tend to work differently depending on whether the company is a private company or a public company. In the interest of being thorough, we’ve included some information that’s relevant to public company warrants below. But for the purposes of startups and other private companies that may depend on Pulley for equity management, not all of this information is necessarily relevant or applicable.
For warrants issued by private companies, the crucial differences between warrants and stock options involve 1) who they’re issued to, and 2) how the exercise price is regulated. Stock options are typically issued to employees or other service providers, and they are regulated so that the exercise price cannot be below the fair market value at the time of issuance. Warrants, on the other hand, are typically issued to outside parties such as investors and banks. Their exercise price is not regulated, so it can be set based on whichever terms the company and these outside parties agree upon.
With that in mind, we’ll call out below which situations apply to public company warrants, private company warrants, or both (as the case may be). Let’s take a look at how different types of warrants work by checking out a few binary comparisons.
American-style and European-style warrants
Despite their very geographically-specific names, American warrants and European warrants can be used all over the world, depending on the business context. These two types of warrants differ primarily in terms of how they’re exercised.
With an American (or American-style) warrant, the holder can exercise the warrant at any time prior to the expiry date. European (or European-style) warrants, on the other hand, require the holder to exercise the warrant on the specific expiry date.
In neither case is the holder forced to exercise the warrant, but the European warrants are more restrictive in terms of when the holder is able to exercise.
Call warrants and put warrants*
Perhaps you’re familiar with calls and puts from the world of exchange-traded stock options. If so, you’ll be happy to know that calls and puts work in a similar way when it comes to warrants.
Call and put warrants differ primarily in whether they gain value from the stock price climbing above the strike price (call) or falling below the strike price (put). Allow us to explain.
A call warrant gives the holder the right to buy shares from the issuing company, while a put warrant gives the holder the right to sell shares back to the issuing company. If you think a stock will increase in value prior to the warrant’s expiry date, you’ll want a call warrant that gives you the right to buy the stock at a lower strike price later. Conversely, if you think a stock will decrease in value prior to the expiry date, a put option lets you sell the stock later at a higher strike price.
* Put warrants will almost never appear within the context of a VC-backed startup or private company. If that’s your realm of concern, rest assured that you’ll be dealing almost exclusively with call warrants and the distinction isn’t something you need to sweat over.
Detachable and non-detachable warrants
In many cases, warrants are attached to newly issued bonds or shares of preferred stock when issued to holders. If the holder is able to sell the warrant separately from the bond or stock it’s attached to, then it’s considered a detachable warrant. As you might imagine, investors generally prefer detachable warrants because they grant a bit of extra flexibility.
Non-detachable warrants, on the other hand, can’t be pried away and sold separately from the securities they’re attached to. So, if you’re an investor who owns bonds with attached warrants, you can’t turn around and sell the warrants without the bonds attached. Similarly, if you sell the bonds, you’ll also be selling the ownership of the warrants.
If a warrant is issued without any pairing or association with a bond or stock, it’s considered a naked warrant.
Covered and non-covered warrants*
Until this point, we’ve been mostly talking about non-covered warrants, i.e. warrants in which the issuing company must issue new shares of stock upon exercise.
There’s another type of warrants called covered warrants in which this is not the case. These warrants are considered “covered” because they’re issued not by the company itself, but by a financial institution that already owns or can access the underlying shares and doesn’t need (and in any case, isn’t allowed) to issue new shares. If a covered warrant doesn’t require the creation of new shares, exercising it will not dilute existing shares.
* The distinction between covered and non-covered warrants is typically specific to public companies.
Key terms and features of a stock warrant
If you’re trying to read through a stock warrant purchase agreement, you probably won’t get very far unless you know some of the key terms associated with warrants. We’ve already discussed several of these terms in this guide, but here’s a quick refresher:
- Strike price: Also known as the exercise price, this is the price at which the underlying security can be bought or sold by the warrant holder.
- Common stock vs. preferred stock: These are two types of company stock that differ in some fundamental ways. Each has its own advantages and disadvantages; learn more in our guide to these different stock types.
- Share class: Especially for private companies, warrants may specify more information about the company stock than simply “common” versus “preferred.” They may also specify which share class (Class A, Class B, etc.) the warrant is exercisable into.
- Issue date: This is the date the warrant was issued to the holder. If a vesting schedule exists (not all warrants require vesting), this date is typically the date that vesting starts.
- Expiration date: This is the date the warrant expires. If the warrant is not exercised prior to its expiry, then it expires and becomes worthless.
Stay on top of warrants and other securities with Pulley
Managing your cap table means juggling lots of different equity types—and failing to accurately record securities as they’re issued can lead to headaches down the road. Fortunately, Pulley makes it easy to record stock warrants and other securities in your cap table.
With Startup, Growth, and Custom plans designed to scale alongside your business, Pulley can quickly adapt to keep pace with your company’s shifting needs. If you think stock warrants might be a part of your company’s equity or fundraising picture, schedule a call with us today to learn how we can help.