Raising new capital from investors can be critical to the livelihood of early-stage biotechnology companies. Clinical stage biotechnology firms often operate with significant losses and need short-term cash to fund continued operations and research & development activities. Developing novel medical treatments requires multiple phases of rigorous testing before they can be approved for commercial use.

Pre-funded warrants are a popular financial instrument in capital raises for early-stage biotechnology companies. These equity-linked instruments offer a number of strategic benefits for smaller companies and investors alike.

Warrants are securities issued by a company that are exercisable for shares of the company’s common stock at a specific price and during a specified timeframe. Once the warrant reaches or exceeds the predetermined exercise price, the holder can buy the company’s underlying shares. For pre-funded warrants, the exercise price is a nominal amount such as $0.00001 per share. They are often structured to be immediately exercisable. Many pre-funded warrants have no expiration date, providing investors with flexibility on the exercise timing.

By issuing pre-funded warrants to investors, clinical-stage biotech companies are able to obtain an upfront cash payment to support their capital-intensive needs. Investors pay nearly the full price of the pre-funded warrants to the company upfront, and only pay a nominal price upon exercise at a future date. From an investor’s standpoint, they are able to benefit from potential price appreciation of the company’s stock down the road if the company achieves clinical milestones. Pre-funded warrants incentivize investors to participate in the potential long-term upside success of the company.

In order to exercise their pre-funded warrants, an investor will submit an Exercise Notice to the company. The Exercise Notice indicates the number of pre-funded warrants the investor wants to convert into shares of common stock.

The pre-funded warrants typically can be exercised on a cash or cashless basis. Cash exercise simply means paying the exercise price of the warrants in cash. Cashless exercise allows holders to exercise their warrants by withholding the portion of shares that the holder would have received if they paid the exercise price. In order to calculate the number of shares that will be received upon cashless exercise of warrants, a standard formula is used that involves dividing [(A-B)(X)] by (A). In this formula, A represents the fair market value of the company’s stock, B represents the exercise price of the warrants and X represents the number of warrant shares that would be issuable upon exercise of the warrants.

In order to avoid onerous public disclosure requirements, some investors will request that the warrants include a beneficial ownership limitation. This provision will restrict the holder from exercising their pre-funded warrants if, after giving effect to the issuance of shares upon exercise of the warrant, the aggregate number of shares owned by the holder would exceed 4.99% or 9.99% of the company’s total shares outstanding.

Transfer provisions allow the pre-funded warrants to be assigned to a new holder under certain circumstances. The holder may submit an executed Assignment Form to the company specifying the name of the assignee.