A stock warrant is a type of derivative that gives the holder the right to buy a share of a company for a specific price within a set window of time or on a specific date. Companies will often issue them to raise capital, or as an employee benefits, recruitment or retention package. While a stock warrant is in many respects similar to a stock option, there are key differences in what they do, who can get them and how they are taxed. Let’s break down the ins and outs of stock warrants and how you might benefit from them.
A financial advisor can help you decide when to act on a stock warrant and other investment moves for your financial plan.
A stock warrant is a contract between a company and an individual. It gives the individual the right to trade that company’s shares at a certain price on or before a certain date. The price is known as the “strike price,” while the date is known as the “expiration date.”
There are several types of stock warrants, all of which are considered alternative investments. A call warrant gives the holder the right to buy the stock for the strike price, while a sell warrant gives the holder of the contract the right to sell the shares for that price. The individual is not required to make these transactions. They simply have the right to do so if they choose.
The stock warrant is good up until its expiration date. After the expiration date, the warrant has expired, and the holder can no longer use it. Under an American-style stock warrant, the holder can exercise his right to buy or sell the shares at any time before the warrant expires. Under a European-style stock warrant, the holder can only exercise his rights on the specified day. Both types of contracts are legal in America and European jurisdictions.
Companies will issue stock warrants for a wide variety of reasons. They are often used to raise capital, in which case the company will sell the stock warrant on the open market. Companies sometimes issue stock warrants as a perk for employees. For example, a firm may offer stock warrants to new employees as a benefit of employment, or may offer stock warrants as part of a retention program for existing employees.
When hiring a new employee it is not uncommon for companies to use a European-style stock warrant. Often companies will issue stock warrants that the new employee cannot exercise for several years, creating incentive for the new hire to stay long enough to capitalize on this benefit.
Some companies issue warrants to make purchases of bonds or preferred shares more attractive. At other times companies issue warrants to fund acquisitions.
Warrants have also been used to rescue struggling corporations. A number of banks issued warrants during the financial crisis of 2008-2009 as part of the Trouble Asset Relief Program. Some Bank of America warrants, for example, gave holders the right to buy BoA shares for $13.30 no later than Jan. 16, 2019. By the time of that expiration date the value of BoA shares were nearly double the original value, netting investors a handsome profit.
Say that XYZ Corp. wants to issue a series of stock warrants to new hires. It could structure its warrants as follows:
This stock warrant gives the holder the right, but not the obligation, to buy up to 1,000 shares of XYZ shares from the company for $50 per share. This means that even if the stock is selling for $80 per share, the holder of this warrant can still buy it at $50 per share. The higher the stock’s price rises, the more valuable this warrant becomes. The holder can exercise this right at any time within the five years. After that, the warrant expires and is useless.
This stock warrant is a little bit different. It gives the holder the right, but not the obligation, to sell up to 1,000 shares of XYZ shares back to the corporation for $75 per share. This means that even if the stock is only worth $30, the company will still have to buy it from the holder of this warrant for $75 per share. The lower the stock falls, the more valuable this warrant becomes. Since this is a European-style warrant, the holder can only exercise it on July 1. Before that date it has not yet matured, while afterwards it has expired.
Companies relatively rarely issue put warrants, because to do so would be to bet against their own stock. This raises numerous legal, ethical and cultural issues that must be navigated during any put warrant issuance.
When a company sells stock warrants, it will also issue the warrant with a price set per share. So, for example, if the stock warrant is for 1,000 shares of stock and is sold at $5, this means that the price for the warrant is $5 per share, or $5,000.
The structure of stock warrants is functionally identical to a stock option, however, there are a few key differences. The most important difference is that stock warrants are issued by the company itself, while stock options are issued by traders on the secondary market. This means that the proceeds raised by a stock warrant go directly to the company. It also, crucially, means that stock warrants can be used to issue new stock.
A stock option can only trade existing shares already on the market. However, because the underlying company itself issues a stock warrant, it can issue new shares as necessary when holders exercise their warrants. As a result, this is often a mechanism that companies use to raise capital in the open market.
Stock warrants are also more flexible in their terms than stock options. A stock option is for a set number of shares and has an expiration date of one year or less. A stock warrant can cover any number of shares and often will have expiration dates far longer than stock options. Expiration dates of five, 10 or even 15 years are not uncommon for warrants.
Tax treatment is another difference between stock options and stock warrants. Unlike stock options, which in an employee compensation context can be eligible for preferential tax treatment, stock warrants do not enjoy the same breaks. Exercising stock warrants results in taxable income that amounts to the difference between the strike price and the price of a share, minus the cost basis.
For example, say you exercise warrants with a strike price of $20 per share to buy 100 shares of XYZ and you originally paid $400 for the warrants. Your total investment is thus $2,400. If the market price on the day of exercise is $40, the shares are worth $4,000 and the difference is $1,600. That amount is deemed to be ordinary income, not a capital gain since you didn’t own the stock before exercising the warrants. It’s advisable to consult a tax expert to make sure you understand and follow relevant tax rules.
Stock warrants, a derivative security that is a common feature of venture capital debt, have many characteristics of stock options. Both have a strike price and an expiration date. However, there are key differences. Stock options are compensatory; warrants are often for raising capital. Stock options are available on the open market; warrant are issued by the company. Tax treatments also differ between the two.
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Eric ReedEric Reed is a freelance journalist who specializes in economics, policy and global issues, with substantial coverage of finance and personal finance. He has contributed to outlets including The Street, CNBC, Glassdoor and Consumer Reports. Eric’s work focuses on the human impact of abstract issues, emphasizing analytical journalism that helps readers more fully understand their world and their money. He has reported from more than a dozen countries, with datelines that include Sao Paolo, Brazil; Phnom Penh, Cambodia; and Athens, Greece. A former attorney, before becoming a journalist Eric worked in securities litigation and white collar criminal defense with a pro bono specialty in human trafficking issues. He graduated from the University of Michigan Law School and can be found any given Saturday in the fall cheering on his Wolverines.
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