A stock warrant is a financial derivative that offers investors the right to buy or sell a stock at a specific price before a set date.
Warrants can be a relatively inexpensive way for investors to bet that a company’s stock will go above or below a certain level–the strike price–over the course of time. The risk with warrants is that they will expire and become worthless.
Warrants have become more prevalent as SPAC deals have boomed since 2020. SPACs are shell companies that go public with the intention of buying a private business. Some SPACs issue warrants or partial warrants to incentivize investors to put money in during the early stages. These contracts can be very lucrative for early investors since they offer the right to buy more shares at just a slightly higher price.
Here’s a closer look at stock warrants, SPAC warrants, as well as what’s important for investors to know about them.
Stock Warrants vs. Stock Options
In many ways, trading warrants can be like trading options. Both stock warrants and stock options offer investors the ability to buy and sell at a certain price, without the investor owning the underlying stock. Call warrants give investors the right to buy the underlying stock, while put warrants give them the right to sell it.
As mentioned earlier, under the terms of the warrant, the price at which the investor can buy or sell a stock is called the strike price. Meanwhile, the date by which they have to decide whether to buy or sell is the warrant’s expiration date. When warrants expire, they lose all value.
Warrants differ from options in two important ways:
1. A warrant is issued by the company that issues the stock. The shares that the investor acquires when they exercise a warrant doesn’t come from public markets, but rather from the company itself. Therefore, when a company issues put warrants, it is agreeing to purchase its own stock from the investor at a certain price. A stock option is a contract entered into by two investors.
2. Stock warrants also differ from options in that they can have expiration dates as far as 15 years in the future. Most options exist for much shorter periods, and rarely more than three years. While warrants are not widely used by US-based companies, they have become more common in China.
How Do SPAC Warrants Work?
When it comes to SPACs, or special purpose acquisition companies, the investors who buy in during the pre-listing process are given “units.” Each “unit” includes a share and a warrant or a fraction of a warrant. The warrants are meant to be additional compensation to pre-listing SPAC investors for agreeing to have their capital held in a trust until the merger.
Historically, institutional investors–hedge funds, mutual funds, and pensions–have had greater access to SPAC units, since units are allocated during the private placement stage of a SPAC deal.
This has been one of the criticisms lobbed at SPACs, with detractors arguing that it gives institutional investors a better risk-reward proposition than retail traders, who typically just buy regular shares in the market without the added potential value warrants can offer.
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Example of Exercising SPAC Warrants
The SPACs’ shares “separate” from the warrants usually 52 days after an IPO. This allows unitholders to trade the warrants and shares separately. The fees for exercising or trading warrants can be more sizable than the fees for trading shares.
Here’s a case example of how an investor may exercise their SPAC warrant. A merger between the SPAC and the target company is completed, and 52 days later, the warrants become exercisable at their strike price, which is typically $11.50 in SPACs.
So let’s say the shares of the combined company are trading at $15, so higher than the strike price of $11.50. That means investors can exercise their warrants and buy additional shares at $11.50 and immediately sell them for $15.
The investor would then pocket the difference between the exercise price of $11.50 and the current share price of $15 for a tidy profit.
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Important Things to Know About SPAC Warrants
While SPAC warrants can be a lucrative opportunity, it’s also important to be aware that each SPAC and the terms of the warrant contracts need to be evaluated by investors on a case-by-case basis.
Remember, warrants offer an opportunity but they can also expire worthlessly. For instance, it’s possible shares of the combined company never rise about the strike price of $11.50, making it impossible for investors to exercise the warrants. It’s also important to know that exercised warrants in a SPAC deal will dilute existing stock investors.
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Furthermore, the regulation of SPACs and their warrants could change. In April 2021, the Securities and Exchange Commission (SEC) changed how SPAC companies can classify warrants on their balance sheet. Many SPACs have considered warrants as equity. But under the new guidelines, in certain circumstances, SPAC companies need to classify warrants as liabilities.
Many SPACs in the pipeline have had to reevaluate their financial statements in order to make sure they’re in compliance with the new regulatory guidelines. Market observers interpreted the SEC’s move as an attempt to cool the red-hot SPAC market.
Why Do Companies Issue Warrants?
The reason that companies issue stock warrants is to raise capital without selling other bonds or stock. Selling warrants also protects the company’s stock from becoming diluted, as would happen with the issuing of new stock. Call warrants will however dilute the shares on the market when investors exercise them.
Because warrants are less expensive than the underlying stock, unproven companies will use them to entice new shareholders. The company makes money on the warrant sale, and on the exercise of the call warrant if the owner buys the underlying shares. And if the warrant expires, the company keeps the purchase price of the warrant.
A company may issue call warrants as a show of confidence for shareholders who want to hedge their holdings of that company’s stock. The company offers the hedge of the call warrant to reassure shareholders while raising capital from the sale of the warrant.
Sometimes, companies will also issue warrants as a way to raise capital during periods of turbulence. For example, some companies issue warrants if they’re headed for bankruptcy.
How to Find Warrants to Invest In
Not every publicly traded company offers warrants. In the US, the companies that tend to issue warrants are not big, Fortune 500 corporations. Instead, they tend to be smaller, more speculative companies.
While there are some online databases of warrants, they’re not necessarily comprehensive and up-to-date. But if an investor has a company they’re interested in investing in via warrants, they can contact that company’s investor relations department. Investors can also go to the company website and search for the word “warrant,” or the company’s ticker symbol, followed by “WT.”
Some warrants can also be traded under the symbol that includes the underlying stock symbol with either a “W” or “WS” before it. Once an investor finds a warrant, most online brokerage accounts will allow them to buy and sell the warrant.
How to Use Warrants
For an investor who owns warrants, the first option is to exercise the warrant. For a call warrant, that’s when the stock price has risen above the warrant’s strike price. If it’s a put warrant, then it means the stock is trading below the strike price.
But a warrant holder has another option, which is to sell the warrant on the open market because warrants can be traded like options. This is one thing to consider if a call warrant is below the strike price. Even if it’s below the strike price, the warrant still has value right up until it expires, though the market may offer you less for the warrant than you paid for it.
Even if the current stock price is higher than the strike price, an investor may choose to hold onto the warrant. That’s because the price could rise even higher before the warrant expires.
Whether buying, selling, or exercising a warrant, most brokers can help an investor get it done. Once purchased, a warrant will appear in a trading account just like a stock or option. But with warrants, like most financial derivatives, most brokers charge higher transaction fees. After the broker contacts the company that issued the warrants and exercises them, the stock will replace the warrants in the trading account.
Other Important Things to Know About Warrants
It’s important to remember that every company that issues warrants does it differently. One company may issue warrants in which five warrants can be exercised to obtain one share of stock. Another company may set the ratio at ten to one or twenty to one.
Some companies can adjust the strike price of their call warrants if the company pays out dividends. This is a twist that can benefit the buyer because warrants with a lower strike price are more likely to be exercised at a profit.
But not every contractual term in a warrant is necessarily to an investor’s benefit. There are some call warrants whose structure allows the issuing company to force investors to sell their warrants if the stock price rises too high above the warrant’s strike price. There are even some warrants whose strike price is designed to rise higher over time, which makes it less likely that an investor will be able to exercise the warrant at a profit.
While it makes sense to study and understand the fine print before buying a warrant or any investment, it’s especially important to double-check those terms and conditions when getting out of the investment, by exercising a warrant, for example.
Stock warrants are a bit like options – but there are some key differences to know. These often-overlooked securities can offer investors an inexpensive way to bet on the long-term success of a company. But they come with potential pitfalls, particularly when it comes to the fact that they can expire if investors don’t exercise them.
Warrants have become more topical since they’re issued in SPACs. SPACs became suddenly hot in 2020 and 2021 as many companies sought an alternate route to going public in the stock market and many famous figures started sponsoring them. In SPACs, early investors often get a share plus a warrant or partial warrant.
These warrants can be lucrative opportunities for early investors to buy shares of the merged company for typically just $11.50 each. However, investors should evaluate each SPAC and warrant carefully. They should also be aware that when unit-holders exercise their warrants, that can dilute existing shareholders.
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