Warrants may be issued as part of a larger capital-raising transaction, such as an equity financing or venture investment. Warrants are derivative securities that provide the holder with the right to buy or sell the stock of the issuing company at a fixed purchase price per share. Warrants can have different structures and features.

Pre-funded warrants are a type of warrant that may be issued as a component of a larger financing transaction to offer certain advantages. They are referred to as “pre-funded” because most of the purchase price is paid upfront and a nominal amount is paid later. The exercise price is typically a nominal amount such as $0.01 per share. As a result, pre-funded warrants are sometimes called “penny warrants.” For example, the upfront purchase price may be $19.99. Later, when the holder wants to exercise their warrants, they will pay the exercise price of $0.01 per share.

Pre-funded warrants are often issued as a deal “sweetener” to incentivize a third party to participate in a larger financing transaction. The issuance of pre-funded warrants may also help some investors avoid exceeding certain ownership thresholds. Some investors may be restricting a company’s voting securities above a certain amount due to internal restrictions or they may want to avoid SEC reporting obligations. For example, if an investor’s ownership in a company’s common stock exceeds 5%, a Schedule 13D filing requirement may be triggered. By holding the warrants, the investor can delay ownership of the company’s common stock until the time that the warrants are exercised.

The company also receives benefits from the issuance of pre-funded warrants. The company receives almost all of the cash proceeds for the warrant upfront, rather than at a later exercise date. The company may also be able to attract certain investors who may not otherwise participate because of concerns about violating certain ownership thresholds.

An investor who holds a large stake in a company’s equity securities may be considered an “affiliate” of the company. Affiliate transactions are subject to a variety of restrictions under U.S. securities laws. Rule 144 under the Securities Act of 1933 provides a safe harbor for the public resale of securities without registration. Under Rule 144, investors who are defined as affiliates must comply with five requirements in order to utilize the safe harbor. Non-affiliates, by contrast, are only subject to the holding period and public information reporting requirements of Rule 144.

Many warrants allow for a cashless exercise, meaning that the holder can exercise their warrants without paying cash. Instead, the number of shares receivable by the holder is reduced by the aggregate exercise price that the holder would otherwise have had to pay in cash. Pre-funded warrants also often come with anti-dilution provisions to offer protections to the holders in the event of a merger, stock split, reorganization or other significant corporate event.

Under the rules of the New York Stock Exchange (NYSE) and Nasdaq, shareholder approval is required for share issuance transactions that exceed 20% of the company’s outstanding common stock. The 20% rule includes common stock and securities convertible into or exercisable for common stock, such as pre-funded warrants. The purpose of the 20% rule is to provide shareholders of the company with advance notice of an upcoming share issuance that could potentially have a dilutive impact. Pre-funded warrants are typically only issued to specific large investors, so notice of a pre-funded warrants offering can be informative to the company’s existing shareholders of the potential for dilution down the road.