Rarely do I see others writing about stock warrants so I was delighted when Marin Katusa went into detail describing the benefits, as well as the potential risk factors, with warrants as outlined below.
The original article by Marin Katusa has been edited here for length (…) and clarity ([ ]) by munKNEE.com to provide a fast & easy read.
The Basics of Warrants
…Like many financial vehicles, warrants have some “moving parts” you need to understand in order to properly use them. Remember, a warrant is a contract that gives the holder the right – but not the obligation – to buy a stock at a predetermined price and at a predetermined point in the future….
Strike Price: Lower is Better
The… “strike price” is the price at which you can buy the stock of the associated company at some point in the future. If a warrant has a strike price of $2, for example, you will be able to buy company stock at $2 at some point in the future…[but until it reaches that price] the warrant has no intrinsic value. If the company [were to] achieve major success and see its stock price soar to $6, the warrant would have an intrinsic value of $4, since it allows you to buy stock for $2 per share, which you could then sell for $6 per share…
When the share price of a stock is trading above the warrant’s strike price, we say the warrant is “in the money” and “out of the money” when the stock price is trading below the warrant’s strike price. The closer the strike price is to the current stock price, the more likely the warrant is to go in the money or to expire in the money, and the more it will be worth…
Expiration Date: Longer is Better
The second aspect of a warrant you need to know about is the “expiration date.” This is the date at which the contract expires. After the contract expires, neither the company nor the holder have any rights or obligations associated with the warrants. If a warrant expires “out of the money,” it is worthless.
The further in the future the expiration date is, the more time a company has to achieve success: and the higher the share price, the more the warrant will be worth. In other words, all things being equal, a “3-year” warrant is worth more than a “1-year” warrant and a “5-year” warrant is worth more than a “3-year warrant. Most warrants issued in private placement have expiration dates 1 to 5 years in the future. It’s rare that valuable “5-year” warrants are issued by companies.
Conversion Ratio: More is Better
The conversion ratio of a warrant is the number of shares applicable to the warrant.
- Some warrants are good for one-quarter of a share, which is known as a quarter warrant. This means you need four warrants to buy one share.
- Some warrants are good for one-half of a share (you need two warrants for one share). These are called “half warrants.”
- Some warrants are good for a full share (you need one warrant for one share). These are called “full warrants.”
Obviously, a full warrant is better than half a warrant.
You want warrants that can convert into as many shares as possible. With all this in mind, the best warrant “sweeteners” for private placement investors will have:
- Lower, rather than higher, strike prices.
- This makes the warrants more likely to go or expire “in the money” and have intrinsic value. If I participate in a private placement at say, $0.50 per share, I’d rather get warrants with a strike price of $1 instead of $2.
- Longer, rather than shorter, expiration dates.
- This gives the company more time to achieve success and a higher share price which gives the warrants more time to go or to expire “in the money” and have intrinsic value. I’d rather get 3-year warrants than 1-year warrants. I’d rather get 5-year warrants than 3-year warrants.
- Higher, rather than lower, conversion ratios.
- You want warrants that convert into as much stock as possible. This is why I prefer full warrants.
Freely Tradable Vs. Non-Tradable Warrants
Freely tradable (listed) warrants trade freely on stock exchanges. In a company’s news release, for example, it will mention something like, “The warrants are listed on the TSX Venture Exchange under the trading symbol XYZ.WT.V” A freely tradable warrant will have “.WT” in its symbol…
Freely tradable warrants are better for the investor because they trade freely and there is a real bid-ask market for them.
Freely trading shares are also much better for the company issuing the warrants. Because many fund managers are prohibited from buying stocks under $1 per share (sub $1 stocks are seen as riskier), freely trading shares allows the company to expand its base of investors. However, the same fund managers are allowed to buy warrants…and become investors in the company.
Another advantage of a freely tradable (or listed) warrant is that it does not have to be above the strike price to be able to realize a profit.
When a non-tradable warrant has a strike price of $1, but the stock is at $0.75, you would not want to exercise the warrant – it’s not in the money – but a freely tradable warrant still has value. If you wanted to, you could sell the warrant on the exchange but you couldn’t do this with a non-tradable warrant.
The best type of warrant is a free trading, full 5-year warrant with a strike price that is 50% higher than the share price at the time of financing. Think of them as the “Ferrari” of warrants.
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