If you are in the market raising junior capital, you will need to realise how warrants are used in structuring your offering. If you’re floating a Private Placement of preferred stock or subordinated debt, your investors will expect to have warrants attached to their security.
A warrant is a security that gives the warrant holder the right to purchase equity at a specific price, within a certain time frame. Without the warrants, the investor or lender would only receive the dividend yield or interest rate on his shares or loan, hardly compensating him for the chance of making the investment. This equity-kicker is what gets investors excited.
Like spread betting, warrants and options are financial tools that allow investors to benefit from rising and falling share prices. They are particularly popular with financial institutions. A warrant is issued by a company and gives the holder the right to buy shares at a particular time in the future at a price set in the present – the exercise price. In the meantime they can be traded on the stock market. The aim is for the exercise price to be …
Warrants are normally expressed as a percent of the ‘fully-diluted’ common stock of the company. These then equates to a certain number of common equity shares.
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Fully-diluted refers to the total number of shares that would be outstanding if all conversions take place; e.g. convertible securities, employee stock options, and warrants, including the warrants which form part of your offering.
Warrants will commonly have a ‘nominal’ exercise price, also known as ‘penny warrants’. In the part of a buyout where the majority of the equity capital takes the form of preferred, the common equity will only have a nominal value. In other situations, the common equity may be valued at a higher number in which event I) the warrants will have an exercise price at the market value of the common equity, or ii) the warrants will have a nominal price, but the number warrant shares will be less.
Anti-dilution rights protect the warrant holder from equity dilution from a subsequent issuance of shares at a price lower than what the investor originally paid.
A simple example-suppose an investor received warrants for 20 percent of the equity for a preferred investment $1 million. If the Issuer subsequently issued another $1 million of preferred with warrants for 30 percent of the equity, the first investor would be diluted from 20% equity to 14% equity if there weren’t any anti-dilution protection language.
Many investors buy and sell warrants, completely ignoring the underlying stock, because often more money can be taken from the warrant transactions. Let’s say you bought those 10 warrants from me at $1 each, for example. You hold on to them and wait till the price of XYZ Company stock climbs to $14 per share rather than using them to buy stock. You then find another investor who is prepared to pay $2 per warrant. The advantage to the purchaser is that he or she acquires the right to buy XYZ Company shares at the bargain price of $11 each. The purchaser will still save $10 in the transaction ($2 × 10 warrants = $20 and $11 × 10 shares = $110; $20 + $110 = $130, versus $140 to purchase 10 shares at $14). The investor has saved money, and you have made $10 from your initial $10 investment, effectively giving you a 100-percent profit.
There are a number of means to address anti-dilution. However, that discussion is outside the scope of this article.
Demand and piggyback registration rights refer to the right of the warrant holder to register his warrant shares for public issuance. The difference between the two types of registration rights is that Demand registration allows the holder to begin the registration of warrant shares for public issuance. Demand registration is usually reserved for majority warrant holders, or warrant holders who’ve a significant ownership. Piggyback registration meant that the warrant holder may have his warrant shares registered along with another holder or the company if there’s a registering of the company’s shares. Piggyback rights are in the interests of minority investors, as only the majority investors will have Demand registration rights.
Tag-along rights give a stockholder the right to join in a transaction to sell his shares if another shareholder is selling his stake.
Preemptive rights give shareholders the right to purchase new securities being issued either by the company prior to them being issued to new, outside investors. In the dilution example above, a preemptive right would have given the first investor the right to buy a proportional quantity of the new issuance to preserve their equity ownership.
To address this sort of situation, XYZ Company decides to issue subscription rights to its current shareholders. XYZ Company gives its investors ‘coupons’ with whom they can buy shares of the recently issued 200 shares for $8 per share instead of the $10 everyone else has to pay by issuing subscription rights. These coupons, or subscription rights, are usually issued depending on the number of shares already owned by the current investor. In the same example, you own 100 shares, and XYZ Company has decided that for each 5 shares held by a current investor the investor will be published one subscription right. You therefore have the right to purchase 20 shares for $8 each.
If you buy 20 additional shares at $8, it will cost you $160. That’s a big break from the $200 it would cost a new investor to purchase those same 20 shares at $10 per share. And the value of your new shares is still $200, just as though you had paid the new-investor price of $10 per share. Thus you immediately make $40.
Note: since there would represent an anti-dilution provision in the shareholders agreement, the anti-dilution provision would require waiver by the shareholders to continue the new issuance.
A Put Option allows the warrant holder to ‘put’ the warrant return to the company. When the warrant is put to the company, the company has a duty to purchase the warrant back from the investor. It is a way for the investor to monetize the value of his equity stake. The price that the company pays for the warrant is a result of the equity value of the company and the percentage of the fully-diluted equity represented by the warrant shares.
A Call Option is a way for the company to ‘call’ in the claims on its common equity. A company may call its equity back from investors if it anticipates a rise in the value of its equity down the road. It is likewise a way for the company to consolidate ownership back to, say the authors of the transaction.
I had a situation once where an investor requested that we eliminate the Call Option. His rationale was that he wished to ride the value and didn’t the equity value get called away from him.
There are no rules relating to the number of years for the investor to have its Put right, or the Issuer to have its Call right, except that typically the advantage is to the investor with the Put right occurring before the Call right. My experience is that Put/Call rights will usually occur in years 4/5 or 5/6.
The issue you’ll face will be determining the value of the equity if and when the Put or Call gets exercised (except if there’s a sale of the company to an unrelated third party).
I have been in proceedings where the equity value to the effects of the warrant was negotiated upfront as the highest of I) a liquidity event (as a sale) or ii) a formula.
For example, if the original transaction was valued at 5x EBITDA, then the valuation for the Put/Call was also 5x EBITDA. Keep in mind that the result of a multiple and EBITDA gets you to an Enterprise Value. This isn’t the same as the equity value. To get to equity value, you will need to subtract debt and add cash (unrestricted cash).
My experience is that if there’s no predetermined formula, the value of the warrant is usually negotiated. The ‘fair market value as defined by a… ‘ Language is for when you cannot agree; however, you should always have this language even if you’ve got a formula.
As the Issuer you may see that the formula is founded on the just-ended fiscal year, but by the time the audit gets completed, there might’ve been a material adverse change in the business such that the agree-upon formula overstates the value of the equity. Conversely, if you’re the investor, events subsequent to the audit may point to a significantly higher equity value than what would be indicated following a formula using the year-end numbers.
Warrants are just another tool that help you raise the capital you need. The trickiest part of the whole warrant conversation will be anti-protection. As the Issuer you’ll want to run through a series of scenarios to make sure you understand how your value will be impacted when anti-dilution triggers kick in.
A warrant is issued by a company and gives the holder the right to buy shares at a particular time in the future at a price set in the present – the exercise price. In the meantime they can be traded on the stock market. Many investment trust shareholders have them as part of their portfolio. The aim is for the exercise price to be cheaper than the future price or projected market value. You can then sell the warrant for …