What are stock warrants and why do companies offer them?

• A stock warrant is an employer-issued contract that gives you the right to buy a company's stock at a set price during a specific period of time, usually years.
• Companies often issue warrants when they need to raise capital for new projects or they may be entering bankruptcy.
• If the value of a company's stock exceeds the warrant's strike price, an investor can purchase shares below market value.

At some point in your investing journey, you've likely come across the terms stock warrants and stock options. These are two similar concepts that can be easily misunderstood. They both give investors the right, but not the obligation, to buy or sell shares of a company's stock at a set price during a set period of time. But that's where the majority of their similarities end.

Stock warrants are often used as a way for a company to raise capital for projects or when facing bankruptcy. They're also commonly added to bonds as a way to entice more investors and reduce the amount of interest paid to bondholders. And issuers have the potential to collect twice on warrants: first on the premium investors pay for the warrant and again if the investor uses the warrant to purchase stock.

Here's a closer look at what stock warrants are, how they work, and what you need to know if you're considering getting into this area of investing.

What is a stock warrant?

A stock warrant is a contractual agreement between a company (the issuer) and an investor (the holder). It gives the investor the right to buy a certain number of shares of stock at a set price within a specific timeframe. There are two main types of warrants: call warrants and put warrants. Call warrants allow you to purchase stock at a certain price in the future. Put warrants allow you to sell stock at a certain price in the future.

The idea is that you purchase a warrant when you anticipate the value of a stock to rise above the set price within the time the warrant can be used. If that happens, you buy shares of stock - known as exercising a warrant - below market price and collect the extra value as a gain. If that doesn't happen, then you lose the money you invested in buying the warrant.

Quick tip: Stock warrants are not common within the US, but they're becoming more popular in conjunction with investing in special purpose acquisition companies (SPACs). The SEC issued a bulletin in May 2021 educating investors about SPACs and the role of warrants with these types of securities.

Understanding how stock warrants work

Warrants are generally issued directly from the company and are most commonly used to raise capital or make investing in bonds more attractive. A bond that has warrants attached to it usually pays out less interest than one without. This is a trade-off because the bondholder has the potential to earn more of a return if the stock price goes up while the warrant is valid.

Investors pay a fee to purchase a warrant, which is collected by the company as capital. If an investor chooses to act on their warrant and purchase shares, the company again takes in money from the sale and gives the investor shares of stock in return.

When an investor purchases a warrant, they don't own anything other than the right to buy or sell stock at some point in the future. The investor doesn't hold any shares, collect any dividends, or have any voting rights a shareholder would have.

Here's a breakdown of the key components of stock warrants:

• Strike or exercise price: This is the price a holder can purchase or sell shares of stock for based on the terms of the warrant. This is also known as the pricing mechanism.
• Expiration date: For US warrants, this is the last day you can exercise a warrant. Warrants issued in other countries are often structured so that the expiration date is the only day you can exercise your right to purchase stock at the strike price.
• Warrant price: This is the premium the issuer charges to purchase the warrant. It's usually set as a price-per-share and provides capital to the issuer upon sale. When a warrant is issued as part of a bond deal, there usually isn't a price attached. Instead, the bondholder is offered a lower interest rate.
• Warrant shares: This is the number of shares the holder can purchase when exercising the warrant and the method of how they will be calculated.

Investing in warrants may be a consideration if you have limited funds but still want to have an opportunity to benefit from stock gains. People also invest in warrants to use leverage, which is a strategy where an investor can tap into borrowed capital to potentially bolster the gains from investment.

Warrant prices are almost always lower than the cost of buying actual shares of stock. This enables you to buy more warrants for your investment than actual shares, thereby increasing the number of shares you could cash in on, should the stock price goes above the strike price.

Quick tip: In the US, investors can usually exercise a warrant up until the expiration date. In Europe and other countries, the expiration date is the only day a warrant can be exercised.

Stock warrant in action

Suppose Company Q is looking to raise some capital for a new project. It announces it will be offering warrants that will enable investors to purchase shares of its stock at $10 per share for the next five years. The company's stock is currently trading at $5 per share. But you think it will go well past $10 per share soon, so you purchase a warrant that gives you the right to buy 100 shares of Company Q stock at $10 per share. The warrant price is $0.50 per share, making your total spend $50 today.

Five years later, Company Q's stock has jumped to $15 per share and you decide to exercise your warrant. You spend $1,000 and get 100 shares that are worth $1,500. In this case, the stock you purchased instantly delivered $500 in value above what you paid for it. Subtract the initial $50 you paid for the warrant and your net is $450.

Purchasing the warrant was a smart financial move in this case. However, if Company Q's stock price never rose above $10 throughout the entire 5-year period the warrant was good, the warrant would have been worthless and you would have lost the $50 you initially invested - provided you held onto the warrant and didn't sell it to someone else during this time. Holders often have the ability to sell their warrants to their investors before the expiration date.

Pros and cons of stock warrants

Stock warrants certainly have their benefits. The most apparent is that you're spending a relatively small amount of money for the chance to potentially earn much more. As described above, the cost of buying a warrant is usually a fraction of the cost of a stock share. If the stock value goes up, you've gotten a bargain. And if your warrant is attached to a bond investment, it could deliver much more in value than the bond interest itself. But if the stock never goes above the strike value, you haven't lost much - most likely much less than if you purchased actual shares.

On the other hand, the downside of warrants is that you don't actually own any shares of stock or have any of the benefits of being a shareholder, such as collecting dividends or voting. You don't earn interest on this kind of investment. If you hold warrants as part of a bond holding, you'll be gaining less return on the bond itself because your interest rate is likely lower than it would be for those without warrants. The biggest drawback is that there's substantial risk in that a warrant can end up being worthless.

Stock warrants vs. stock options

Stock warrants and options are similar in that they allow investors the option to buy or sell shares of stock at a set price within a specific timeframe. They're structured similarly, but while warrants are contracts between a company and an investor, stock options are between individual investors. Options also usually have expiration dates within months of purchase, whereas warrants can be active for years.

When a warrant is executed, the company issues new shares of stocks. This increases the total number of shares and dilutes the percentage of the company existing shareholders own. This doesn't happen when options are exercised because shares that are already in the market are being redistributed, not created.

"Where the longest an option would go, that's usually kind of the shortest a warrant would go,"says Daniel Patterson, a certified financial planner and owner of Sweetgrass Financial Planning. "And the big thing is that it dilutes, actually issuing new shares instead of trading existing shares on a secondary market or something like that."

The main purpose of a stock warrant is usually to raise capital through the collection of premiums and incentivizing purchasing stock, both of which result in cash flow directly into the company. Robert Johnson, professor of finance at Creighton University describes options as "side bets between investors." Premiums associated with options are not paid to the company whose stock is being optioned, nor does the company receive any money when an investor exercises their option. Transactions are strictly between investors.

Types of stock warrants

Like many things in the investment game, there are lots of types of stock warrants you may come across. These are the most-common terms you'll see associated with warrants:

• Traditional warrants: This is a type of warrant that's offered as a detached part of a bond or preferred stock deal. These are used as incentives to encourage investment and can be sold individually while the holder keeps the bond or preferred stock.
• Naked warrants: This is a term for a basic right to purchase/sell stock with no attachments.
• Wedded warrants: This is a type of warrant attached to a bond. You can't sell off the warrant without also selling the bond.
• Covered warrants: These warrants are not issued directly by the company, but by financial institutions. They buy the warrant from the company, then sell it to an investor.

The financial takeaway

Stock warrants can be tricky to navigate, particularly because they come with a decent amount of risk. You're betting your hard-earned money on how a company may perform in the future. And there are a ton of factors that can influence that kind of outcome.

However, they can pay off when executed right. If you're interested in exploring this type of investment, it's a good idea to speak with a financial professional who has experience in these kinds of transactions before making any decisions. From there, only time will tell if your gamble pays off.