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A warrant is a contract entitling the warrant holder to buy shares of stock of a company. It is not stock itself. It is merely a contractual right to buy stock.
A warrant will set out:
the price per share at which you can buy the shares (for example, $0.01 per share)
the type of shares you have the right to buy (common or preferred)
the period of time during which you can exercise the purchase right (for example, two, five, or ten years).
Warrants are fundamentally the same as stock options (both are rights to purchase stock), but warrants and stock options differ in their format, complexity, and the contexts in which they are used. Warrants are usually issued in investment transactions, such as convertible debt financings that include warrant coverage, and stock options are used for compensatory purposes (a stock option for employees and advisors, for example).
Warrant coverage most frequently arises in the context of a convertible debt financing, but it can also arise in the context of a preferred stock financing.
Warrant coverage has fallen out of favor in convertible debt financings because of the tax issues (forced inclusion in income on an accrual method basis of phantom interest income) and the ability to mirror (at least in part) some of the economics of a warrant through discounts and caps in convertible notes while avoiding the tax issues associated with warrants.
Very rarely, warrants are issued as stand-alone instruments—meaning, by themselves, with no accompanying purchase of a note or stock.
A warrant can be very valuable. Suppose you had acquired a ten-year warrant to buy 100K shares of an early stage company’s stock for $0.40 a share. Five years later the company goes public and the shares are worth $40 a share. You can now exercise your warrant for $0.40 a share, and sell the shares on the open market for $40 a share.
In addition to the exercise price, the type of shares for which the warrant is exercisable, and the duration (term) of the warrant, warrants typically also have the following terms:
A net exercise provision (“net exercise” means that if the shares underlying the warrant have a value greater than the exercise price per share at the time of exercise, rather than paying cash to exercise the warrant, you can pay the exercise price with shares that would otherwise be deliverable on exercise).
An automatic exercise on a “net exercise” basis prior to termination (you would hate to have an in-the-money warrant suddenly terminate; an auto-exercise provision prevents that from happening).
Notification of a pending sale of the company and other material events.
Adjustments to the purchase price and number of shares covered for capital restructures, such as a stock split or stock dividend.
Calculating The Number Of Shares Represented By Warrant Coverage
When negotiating a financing, you might hear a founder say, “We are offering 50% warrant coverage.” Calculating the number of shares you are entitled to purchase based on a warrant coverage percentage requires the following inputs:
the amount of your investment
the exercise price per share of the warrant
the warrant coverage percentage.
exampleSuppose you are investing $200K in a convertible debt investment, and the deal carries 50% warrant coverage. The price per share of the company’s shares is not yet set because the company is offering this warrant coverage to you in a convertible debt round and your warrant is going to be exercisable into the preferred stock sold in the next round at that round’s price. How do you calculate the number of shares covered by your warrant?
In this example, the number of shares represented by the warrant coverage will depend on the price per share in the fixed-price round, once that is set. Suppose you invest $200K in the note round and the company ultimately consummates a “qualified financing” at $2.50 per share. In that case, you would be entitled to purchase 40K shares under the warrant. How?
Start by calculating the number of shares from the conversion of your investment, excluding the warrant—$200K, divided by the price per share in the offering, $2.50, equals 80K shares. Now multiply the 80K shares you get from the conversion by the warrant coverage percentage, 50%, to get 40K additional shares from the warrant.
You could also start with your investment amount, $200K, multiply that by the coverage percentage (50%) to get $100K, and divide that by the price per share, $2.50, to arrive at 40K.
Logically, this makes sense. You were offered 50% warrant coverage, or the right to buy an additional number of shares equal to half the shares you purchased when your note converted. What type of shares you get to buy and what price depends on the terms of the warrant as mentioned above. Typically the warrant coverage is for the type of shares sold in the next round, at the next round’s price. However, if no next round occurs, you will need a “default” class of shares to convert into, which might be common stock or a new series of preferred stock described in the warrant.
Tax Issues With Warrants
If you buy a note with a warrant, be aware that special tax issues arise.
Original Issue Discount
Assume you invest $100K for a note with a principal amount of $100K and a warrant. The IRS will view the note and the warrant together as one investment “unit.” It will deem that the $100K you invested must be allocated between the note and the warrant. This will result in the note having what is referred to in the tax law as the original issue discount (OID). OID must be included in taxable income on an accrual basis.
For example, assume the IRS determines that the fair market value of the warrants received is $20K. This would mean that you would have $20K of OID in the note, and would have to include that in taxable income over some period of time. It will be phantom income on which you have to pay tax. This tax issue is one reason note and warrant financings have fallen out of favor. More common today are note financings without warrants. Instead of warrants, notes have conversion discounts.
Investment Warrants vs. Services Options
There is a significant tax difference between warrants issued in connection with an investment transaction, and warrants or options issued in consideration for services rendered.
If you receive a warrant or a stock option in exchange for service rendered, then the same rules for nonqualified stock options apply:
Section 409A applies, which means that if they are priced below fair market value the optionee will be subject to 20% penalty taxes and interest upon the vesting of the options.
If priced at fair market value on grant, the receipt of the option is not taxable.
If priced at fair market value on grant, the vesting of the option does not give rise to tax.
On exercise, ordinary income tax is owed on the difference between the fair market value of the stock received and the exercise price.
On the other hand, if you acquire a warrant in connection with and as part of an investment, then the exercise of the warrant does not give rise to any taxable income, even if at the time of exercise there is a significant spread (meaning, the fair market value of the stock at the time of exercise is greater than the exercise price).
What About A Warrant Financing?
It is rare, but we have seen circumstances where someone will want to buy just a warrant in a company. Warrants are typically not purchased alone, so a “warrant financing” is atypical. Why? Think of it this way. Why would you invest in a security that only entitles you to become a stockholder if you later “exercise” the warrant? A warrant does not make you a creditor of the company, because a warrant is not a promissory note. Nor does a warrant make you a stockholder of the company, because it has to be exercised before it is converted to stock.
If you have the opportunity to buy a warrant, standing alone, and you want to go ahead, make sure the warrant has the terms that you desire, including, at least: (i) a lengthy term (like 10 years); (ii) an automatic exercise prior to termination if in the money: (iii) adjustment provisions in the event of a stock split; (iv) a net exercise provision; (v) an attorneys’ fees provision (and if possible, a favorable venue clause).