Capital is one of the foremost concerns for startups. You may often wonder if you have enough capital or how you can get more capital. Regardless of whether you need a capital influx to keep the company afloat or if you just need a little more capital to start a new project, there are many financial instruments that can be used to raise capital. One of those financial instruments is warrants. This article will explain the basics of what warrants are, how they can help you, and how to account for warrants.
What is a warrant?
A warrant is a financial instrument that provides the holder of the warrant the right, but not the obligation, to buy a company’s stock in the future at a predetermined price. Companies may include warrants in employee compensation packages or as part of a capital raising transaction. Companies may also sell warrants directly to investors. Typically, a warrant will have an expiration date, a date at which the warrant will expire and will no longer be exercisable, and an exercise price. The exercise price is the price at which a warrant holder can exercise the warrant and purchase company stock. Generally, the warrant may be exercised at any point before the exercise date. To exercise a warrant, the holder pays the company the exercise price in exchange for a share of the company’s stock. This gives the holder the potential opportunity to make a profit if the market price of the company’s stock rises above the exercise price of the warrant.
To help understand the mechanics of warrants and how they can provide benefit to warrant holders, we will consider a simple hypothetical example. Bob believes that the stock price of General Company is going to increase over the next few years. So, on 1/1/20X1 Bob decides to purchase 100 warrants for $10 per warrant, or $1,000 total. Each warrant gives Bob the right to purchase one share of General Company stock for $15. On 1/1/20X1, General Company’s stock is trading at $22 per share. Bob waits three years without exercising his warrants. On 1/1/20X4, General Company’s stock price is now $60. Bob decides to exercise all of his warrants on 1/1/20X4 by paying General Company $1,500 ($15 X 100 warrants) for 100 shares of General Company stock. Bob now has $6,000 ($60 X 100 warrants) of General Company stock for which he paid $2,500 ($1,000 to buy the warrants, $1,500 to exercise).
How are warrants different than call or put options1? Warrants and options are very similar. However, there are significant differences between the two. Warrants are issued directly by the company whose stock underlies the warrant. Options, on the other hand, are financial instruments typically created by other institutions or individuals. While options are usually traded on an exchange, most warrants are traded directly between individuals (also known as over-the-counter2). Additionally, warrants are dilutive, meaning that when exercised the company issues new shares of stock. In contrast, options (with the exception of employee stock options) are non-dilutive, meaning that when you exercise an option a current stock owner sells their stock rather than the company issuing new stock. Typically, warrants are outstanding longer than options before they expire. Warrants are generally issued with expiration dates within 3-5 years, whereas options usually have expiration dates within a year or two.
How are warrants used and how can warrants benefit my company?
Generally, companies issue warrants for one of three reasons: (1) to make their securities more attractive, (2) to give existing shareholders the first right to purchase new shares, and (3) to incentivize and compensate employees. This article will address the first two reasons listed above. The third reason, to incentivize and compensate employees, is aligned with the discussion addressed in our other articles Stock Options 101 and Startup Equity Taxation.
Using warrants to make a company’s securities more attractive is a very common reason companies issue warrants. Companies often need to raise capital. Unfortunately, because of market conditions or a company’s recent financial struggles, it is not always possible to receive favorable terms or rates when raising capital. This is when warrants can be beneficial. We will illustrate this with an example. General Company is looking to raise $10,000,000 of debt capital. However, General Company has had less than stellar performance recently and consequently, banks are not willing to give General Company a loan with an interest rate lower than 10%. General Company needs this loan, but really does not want to be locked into an interest rate of 10%. General Company goes back to the bank and says they will give the bank $200,000 of warrants (also known as a kicker3) if the bank will give them an 8.5% loan. The bank agrees, and General Company obtains the loan at the rate they desired. In this case, General Company was able to receive the financing and rate they wanted by giving the bank the right to purchase General Company stock at a set price in the future. While this deal may cost General Company stock in the future, the company received the capital it required. Warrants can also be used as kickers in common or preferred stock offerings.
Warrants are also used when a company is offering additional shares and wants certain existing shareholders to have the right to purchase the shares before new shareholders. In this case, when the existing shareholders purchase their shares as part of the deal they also purchase or receive warrants that allow them the right to purchase additional shares in the future. These warrants will either give the existing shareholders the right to purchase at a predetermined price or may only give them the right to purchase before anyone else, but at the current market price.
Warrants can be helpful as you look to attract investors and raise capital early in the life of your company. Raising capital as a startup is inherently more difficult than raising capital as a mature company. An unproven company is viewed as a risky investment. Warrants can go a long way toward enticing people to invest in your company. For example, if an interested investor is worried their ownership might be diluted during future rounds of funding, you can offer the investor warrants that they can exercise the next time you look for funding. That way you can receive capital from that investor and they can feel more secure in their investment. If you want to raise capital but do not want to give up a significant ownership percentage, then you may consider getting a loan. However, as a young startup you may not receive the interest rate you are looking for or may not find many interested banks. In this case, you can do what General Company did in the example above. Including warrants will increase your chances of obtaining debt financing from a bank. This type of debt financing is very common in the startup world. Both debt and equity financing for startups are explained more in our articles Overview of Startup Financing, Types of Startup Investors, and The Stages of Startup Financing.
How do I account for warrants?
The accounting for warrants can range from simple journal entries to complicated, technical valuation and accounting. This article will address the basics of accounting for warrants. If you need assistance with your technical warrant accounting, we recommend you reach out to a technical accounting firm.
As mentioned above, warrants are typically issued in conjunction with a debt or equity offering. Thus, this article will explain how to account for warrants attached to debt or equity.
Step 1: Is the warrant classified as a liability or equity?
When accounting for warrants in connection with a debt or equity offering, the first step is to determine if the warrants should be classified as a liability or equity. According to ASC 480-10-25-8 and ASC 480-10-25-14, a warrant is classified as a liability if the warrant obligates the issuer to repurchase its shares by transferring an asset. A warrant can also be classified as a liability if it (conditionally or unconditionally) obligates the issuer to settle the warrant by issuing a variable number of shares if the monetary value of the obligation is based on a predetermined fixed amount, variation in something other than the issuers stock price, or variations inversely related to the issuers stock price. Therefore, if you are issuing a warrant that (1) requires you repurchase your shares by transferring cash or any other asset, or that (2) requires you transfer a variable number of your shares equal to a fixed monetary amount or a variable amount that is tied inversely to your stock price or another index then that warrant is classified as a liability. Any other warrant would be classified as equity.
Step 2: Calculate the fair value of the warrants.
Calculating the fair value of a warrant can be a complicated and imprecise process. However, there are many methods for valuing warrants such as the Black-Scholes Model or the Cox, Ross, and Rubinstein binomial pricing model. Due to the difficulty of this process warrant valuation will not be discussed in this article. For more information on the importance of properly valuing warrants please see our articles on 409A Valuations and Cheap Stock.
Step 2(a): Calculate the value of the debt or equity the warrant is attached to.
If the warrant is classified as equity, then you will use the fair value of both the warrant and the debt or equity you are offering to allocate the sale proceeds. Therefore, you will need to determine what the value of the debt or equity you are offering would be without the warrant. There are many ways to do this. If you have recently issued a similar round of debt or equity without warrants and your valuation has not changed significantly since then, you can use the value per shares of the previous round of debt or equity as the value of your new round of debt or equity without the warrant. If you have not recently issued a round of debt or equity, then you will need to do a fair value calculation of the new securities being offered. This can either be done in house or by an outside valuation firm.
Step 3: Allocate the value of the warrant and the securities.
Once you know the value of the warrants and the securities being offered on a standalone basis you can allocate the portion of the sale proceeds to the securities and the warrants. This is done differently depending on whether the warrants are classified as liabilities or as equity.
Warrants as equity: If the warrants are classified as equity, then the sale proceeds are allocated according to the relative fair value of the securities and the warrants independently. For example, if the fair value of the bonds being offered is $1,500, the fair value of the warrants is $500, and the proceeds received were $1,500, then the proceeds would be allocated 75% to the bonds and 25% to the warrants, as shown below. This is known as the proportional method.
The amount allocated to the warrants will be recorded as additional paid-in capital – warrants. The bonds will be credited for full fair value with a debit to the discount on bonds account offsetting the value of the bonds to the actual amount allocated to the bonds. Following our example above, the journal entry would be recorded as follows:
Warrants as liabilities: If the warrants being offered are classified as a liability, then the sale proceeds should be allocated first to the warrants at the full fair value of the warrants. The remaining proceeds should then be allocated to the debt or equity being offered. For example, if we use the same facts as above, then $500 of the proceeds would be allocated to the warrants and the remaining $1,000 would be allocated to the bonds.
In this case, the journal entry to record the warrants would be $500 to a warrant liability account, rather than additional paid-in capital. The remaining $1,000 would be recorded as a credit to the bond account with the offsetting debit to discount on bonds being $500 (the value of the warrants) as follows:
It is also important to note that the warrant liability needs to be remeasured each reporting period and adjusted to fair value. The changes in the fair value of the warrant liability will be reflected on the income statement.