By Eric Reed
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. Learn the ins and outs of stock warrants and how you might benefit from them. And consider consulting with a financial advisor as you go about deciding whether to act upon a stock warrant.Stock Warrants Defined
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 to 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.Examples of a Stock Warrant
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.Stock Warrants vs. Stock Options
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.Taxes on Stock 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.The Bottom Line
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.Investing Tips
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