What Is a Stock Warrant?
Stock warrants are securities that have payoffs similar to plain vanilla stock options. They offer holders the option (but not the obligation) to buy stock in the issuing company at a preset price anytime during a specified term. While not particularly common in the US, stock warrants are an important part of many companies’ capital-raising and corporate control activity.
Reasons for Issuing Warrants
Generally, there are two reasons a company would issue warrants. One is to entice better terms from a lender. When packaged with debt, warrants create a more attractive financing opportunity because they allow the lender to share in any future stock increases, a substantial upside potential that the typical fixed-income loan couldn’t provide on its own. In exchange, the issuer may get a lower interest rate on its broader debt agreement. This can make a funding package more accessible to a company with below-average credit, for example.
The other reason to issue warrants is to encourage sales. Suppose a manufacturer wants to increase sales through a particular distributor. Issuing warrants to that distributor provides an incentive to sell more of the manufacturer’s product, since rising revenue could also raise the warrants’ value. In this sense, warrants can be an attractive alternative to bonuses and commissions being paid to other companies, because they don’t require the issuing company to give up some of its profits at a cash cost. Instead, they provide equity, which can gain value and be liquidated at a future time in the market.
These are a few ways in which warrants and similar instruments can represent a good opportunity for issuers and holders alike.
That said, unlike stock options, fair valuing warrants can be quite tricky to do. Since warrants are so similar to stock options, many companies rely on a standard option pricing technique such as the Black-Scholes formula. Technically this may be inappropriate, even for plain vanilla warrants, because the Black-Scholes formula doesn’t account for warrants’ dilutive aspects. So if this dilution isn’t incorporated, the Black-Scholes formula overestimates the fair value of warrants.
Other warrants have more complex, custom features that make the Black-Scholes formula clearly improper to use. For example, lenders receiving warrants know that the company is likely issuing warrants to other parties, which would dilute the lenders’ stake in the company. As such, they often require protection from dilution via provisions that adjust features such as the strike price or number of shares covered by the warrant in case certain events take place. Typically called “down-round” or “ratchet” provisions, they’re part of the warrant agreement itself. The terms specify how the variables will be adjusted upon the occurrence of certain events, and the adjustments can come in a variety of forms.
Under ASC 820: Fair Value and Disclosures, the valuation process for these types of “complex” warrants typically requires custom modeling of the protections along with periodic (usually quarterly) updates of the value. To get the accounting for the instruments right, it’s also necessary to determine if the warrants fall under the scope of ASC 480-10: Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. Due to the many types of warrants that a company can issue, there’s no “one size fits all” approach. Only a careful analysis will determine the correct valuation and accounting approach to follow.
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