Stock Warrants: Origin, Purpose and Key Differences from Options
Stock warrants and stock options are both financial contracts between two parties. An investor can use them to generate profit in an investment portfolio. Both warrants and options enable the holder to purchase or sell a company’s stock at a given price and on a given date. Although they have a number of similarities, warrants and options differ from each other in fundamental ways. The primary distinctions are in how they originate, their respective lifespans, and the purpose of issuance.
Differences Between Stock Warrants and Options
A warrant is a type of long-term security that provides the holder with the right, but not the obligation, to buy a company’s stock at a predetermined price on a predetermined time in the future. The price at which a holder is allowed to purchase the common shares of the corporation is called the exercise price. Once the expiration date occurs, the warrant will no longer be exercisable. Warrants are often issued as a reward to loyal investors to enable them to potentially buy the company’s stock down the road at an agreed-upon exercise price. By purchasing the stock at a point when the exercise price is lower than the price that the stock is trading, the stock warrant recipient will make an immediate profit.
Many of these characteristics make warrants similar to options. Options provide investors with the right, but not the obligation, to buy or sell a company’s stock at a predetermined price on a predetermined date. Like warrants, there is an exercise price and expiration date for options. For a call option, the buyer will profit when the stock increases in price above the exercise price.
Distinct Features of Stock Warrants and Options
Despite the fundamental similarities in these financial instruments, warrants and options have a number of distinct qualities. Warrants are issued by the company whose stock underlies the warrant. Trading takes place in the over-the-counter market, individual trade directly among themselves. In contrast, third parties issue options. The third party is most often an exchange such as the NYSE or NASDAQ.
Another key difference is that warrants are dilutive while options are non-dilutive. The dilutive nature of warrants means that the company doesn’t actually isue new shares upon exercise of the warrant. Exercise results in a decrease in the ownership percentages of existing stockholders.
Warrants generally have significantly longer durations than options. There tends to be a period lasting a number of years between the dates of issuance and expiration of warrants. Warrants can last for up to 15 years. In contrast, options are measured in periods of days or months. Options typically last for no more than a couple months. From an investment perspective, stock options are a superior short-term portfolio strategy while warrants are better for building a long-term investment portfolio.
Differences in Corporate Purposes for Issuance
There are differences in the corporate purpose behind the issuance of warrants and options. Companies issue warrants for the purpose of raising capital for the company. They have longer durations in order to attract investors by giving them the warrants as a reward for providing a longer-term investment in the company. Companies use options to incentivize strong employee performance.
There are also differences in the tax treatment of warrants and options. Unlike with options, no taxes come due upon exercising the warrant. The investor would simply be responsible for paying to purchase the shares. The exercise of stock options is subject to either a short-term capital gains tax or ordinary income tax.
The Variety of Stock Warrants
A number of different types of warrants exist. These categories include traditional warrants, naked warrants, and covered warrants. Traditional warrants are issued accompanied by bonds or preferred stock. This is a better for the buyer because they can sell the warrants without selling the attached bond or preferred stock. Participants sometimes call traditional warrants detachable warrants for this reason. The key factor that differentiates naked warrants from traditional warrants is that naked warrants are issued on their own, not in conjunction with bonds or preferred stock. For this reason, participants sometimes refer to naked warrants as non-detachable warrants or wedded warrants. Financial institutions issue covered warrants, not the company itself. The warrants are “covered” by the issuing institution, which owns or can easily obtain the underlying shares. The implication is that no new issuance of common stock occurs when a covered warrant is exercised.
In the corporate restructuring and bankruptcy context, shareholders are sometimes offered the right to purchase new warrants. Companies that enter Chapter 11 bankruptcy and emerge often must adopt a reorganization plan. By proposing a reorganization plan in which shareholders receive warrants, investors can make money by exercising the warrant if the reorganized company’s share price rises above the warrant price.
An Example of Restructuring from the 1980s
An example illustrating the value of stock warrants in the restructuring context is that of Chrysler in the early 1980s. Chrysler issued 14.4 million warrants to the government when the company was near bankruptcy. The purpose of the warrant issue was to attract investors. However, this issuance ended up being disastrous for Chrysler. The company issued the warrants at an exercise price of $13 per share when the stock price was only $5. Unexpectedly, Chrysler’s stock price later climbed to $30 per share, requiring the company to pay $311 million to the government for all the stock warrants sold.