Wall Street has all kinds of investment tools and strategies that can potentially add more cash to an investor's portfolio.
One of the lesser-known models is the stock warrant, which gives investors some flexibility down the road to take advantage of good financial market scenarios.
What's a stock warrant and why would companies offer them -- and why and how would investors use stock warrants?
Answers to all of the above and more can be found below, as we take a deep dive into the stock warrant.
What Is a Stock Warrant?
A stock warrant is a financial contract between a company and investors that gives the investor the option to purchase the company's stock at a specific price and by a specific date. A stock warrant allows the holder to receive newly issued stock from the same company that provided the warrant. While the warrant expires after a certain date, the investor is still allowed to make the stock warrant purchase (via common stocks) at a later date if he or she chooses.
Warrants are often given to company bondholders as a "sweetener" for deep-pocketed investors, or to valuable employees for a "job well done."
Structurally, stock warrants are used to attract buyers to a company's stock, potentially enabling the recipient to buy the stock down the road at the warrant's "strike price" (the agreed-upon price) at a price lower than the stock may be trading.
For example, let's say ABC Corp. gives the stock warrant holder a contract to purchase 100 shares of the company at $20 per share (the strike price) over the next 10 years. If at any point in time during that 10-year period the recipient buys the stock at the strike price even if it's trading above that price, that's a good deal for the stock warrant recipient, who earns an immediate profit on the stock purchase.
Or look at the above stock warrant example another way.
You, as a valued investor or employee of a company, are given a stock warrant that allows you to buy ABC stock at $20 per share on Sept. 1, 2019. You, as the owner of the warrant, execute the warrant contract on that date, and purchase ABC stock at $20, even if it isn't trading at that price.
In return, you are then given one share of ABC stock. Consequently, if the stock is trading at $30 per share and you paid $20 per share, you've already earned a 33% profit on the transaction.
On the other hand, if the price of ABC's underlying stock falls to $10 per share, you're "out of the money," as the strike price is significantly higher than the actual stock price.
Plus, you don't have voting rights as the holder of a stock warrant, and you don't get paid dividends, either.
What's in a Stock Warrant?
A look under the hood reveals several features and components of a stock warrant. Here's what's inside the financial instrument:
- The 'Heads-Up' Notice. In any stock warrant deal, the recipient can let the company know up front when he or she will exercise their right to purchase the underlying stock. Once the company that provided the stock warrant gets that purchase notice, it will issue new stock shares to allow for more shares of its stock to be traded. This will increase the company's total shares of stock, which can dilute the price of the stock.
- The Pricing Mechanism. A company will declare a stock warrant strike (also known as the exercise price) after it issues a new bond offering.
- The Expiration Date. Any stock warrant comes with an expiration date, which is listed on the contract.
However, here's a word of caution on getting stock warrants in the U.S. and abroad.
Stock warrants given in the U.S. allow the recipient to execute the warrant at any time leading up to and including the expiration date. That's not always the case overseas. For example, a stock warrant in some European countries mandates that the recipient exercise the warrant only on the expiration date.
How Do Stock Warrants Compare to Stock Options?
At first glance, stock warrants emulate stock options, as they both share similar features and benefits. But they have important differences, too.
Let's take a look and see how stock warrants are the same and where they contrast.
Getting a grip on warrants vs. options means understanding how both investment products are defined.
Both are investment/financial contracts that allow someone to purchase a specific company's stock at a specific price and time. Each is also designed to give investors the opportunity (but not a guarantee) of making a profit on that investment. Both are also traded widely on major financial exchanges like the New York Stock Exchange or the Nasdaq Stock Market.
But this is pretty much where the similarities end between stock warrants and stock options. Here are the primary differences:
Stock Warrants Are Used to Raise Capital. Companies issue stock warrants in a large part to raise capital. Not so with stock options, which are ways investors can place bets on a company's stock. However, the company itself doesn't make any money on stock-option transactions.
Timetables Are Different. The investment window is wide open for stock warrants, which can last as long as 15 years in some cases. By contrast, stock options often expire in a matter of days, weeks or months. That's why market makers say that stock options are a better short-term portfolio strategy than stock warrants. Conversely, stock warrants are deemed as a superior long-term investment strategy.
Tax Differences. Stock warrants and stock options come with different tax rules, too. Taxable consequences from the use of stock warrants depend on how they're used. The taxes that may be attached to a stock warrant can be complicated; they are usually taxed once the warrants are exercised.
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