A stock warrant is a type of derivative that gives the holder the right to buy a share of a company for a specific price, within a set window of time or on a specific date. Companies often issue stock warrants to raise capital, or as an employee benefits, recruitment or retention package. While a stock warrant is in many respects similar to a stock option, there are some key differences in what they do, who can get them and how they’re taxed. Let’s break down the ins and outs of stock warrants, as well as how you might benefit from them.
A financial advisor can help you decide when to act on a stock warrant and other investment moves for your financial plan.
What Are Stock Warrants?
A stock warrant is a legal agreement between a company and an individual, granting the individual the right to buy or sell the company’s shares at a specified price within a set time frame. The agreed price is called the “strike price,” and the set time frame ends on the “expiration date.”
There are different types of stock warrants, all considered alternative investments. A call warrant allows the holder to purchase shares at the strike price, while a put (or sell) warrant enables the holder to sell shares at that price. While you aren’t obligated to make these transactions, you have the option to do so.
The stock warrant remains valid until its expiration date. After that date, the warrant expires, and the holder can no longer use it. With an American-style warrant, the holder can exercise their right to buy or sell at any point before the expiration date. In contrast, a European-style warrant can only be exercised on the expiration date. Both types of warrants are legally recognized in American and European markets.
Why Are Stock Warrants Issued?
Companies issue stock warrants for a variety of reasons, often as a strategic tool to raise capital. In such cases, the company sells the warrants on the open market. Warrants can also be used as an incentive for employees. For example, some companies may offer stock warrants to new hires as part of their employment package. Or use them in retention programs for existing staff.
It’s common for companies to offer European-style stock warrants to new employees, which cannot be exercised for several years. This structure encourages long-term commitment, as the new hire must stay with the company to benefit from the warrant’s potential value.
Stock warrants are sometimes issued to make bond or preferred share purchases more attractive. They can also serve as a means to fund acquisitions.
In times of financial distress, warrants have also been used to help rescue companies. During the 2008-2009 financial crisis, several banks issued warrants as part of the Troubled Asset Relief Program (TARP). For example, some Bank of America warrants allowed investors to purchase shares at $13.30 by January 16, 2019. By that time, the value of the shares had nearly doubled, offering investors significant returns.
Examples of a Stock Warrant
As an example, let’s say that XYZ Corp. wants to issue a series of stock warrants to new hires. It could structure its warrants as follows:
- American-style call warrant for 1,000 shares of XYZ Corp. stock (the asset) at $50 (the strike price) within five years (the expiration date).
This stock warrant gives the holder the right, but not the obligation, to buy up to 1,000 shares of XYZ shares from the company for $50 per share. Even if the stock is selling for $80 per share, the holder can still buy it at $50 per share. The higher the stock’s price rises, the more valuable this warrant becomes. The holder can exercise this right at any time within the five years. After that, the warrant expires and is useless.
Let’s look at another example:
- European-style put warrant for 1,000 shares of XYZ Corp. stock (the asset) at $75 (the strike price) on July 1.
This stock warrant is a little bit different. It gives the holder the right, but not the obligation, to sell up to 1,000 shares of XYZ Corp. shares back to the corporation for $75 per share. If the stock is only worth $30, the company still has to buy it from the holder for $75 per share. The lower the stock falls, the more valuable this warrant becomes. Since this is a European-style warrant, the holder can only exercise it on July 1. Before that date it has not yet matured, while afterwards it has expired.
Companies relatively rarely issue put warrants, because to do so would be to bet against their own stock. This raises numerous legal, ethical and cultural issues that must be navigated during any put warrant issuance.
When a company sells stock warrants, it will also issue the warrant with a price set per share. Let’s say a stock warrant is for 1,000 shares of stock. If it’s sold at $5, this means that the price for the warrant is $5 per share, or $5,000.
Stock Warrants vs. Stock Options
The structure of stock warrants is functionally identical to a stock option; however, there are a few key differences. The most important difference is that stock warrants are issued by the company itself. Meanwhile, stock options are issued by traders on the secondary market. This means that the proceeds raised by a stock warrant go directly to the company. It also, crucially, means that stock warrants can be used to issue new stock.
A stock option can only trade existing shares already on the market. However, because the underlying company itself issues a stock warrant, it can issue new shares as necessary when holders exercise their warrants. As a result, this is often a mechanism that companies use to raise capital in the open market.
Stock warrants are also more flexible in their terms than stock options. A stock option is for a set number of shares and has an expiration date of one year or less. A stock warrant can cover any number of shares and often will have expiration dates far longer than stock options. Expiration dates of five, 10 or even 15 years are not uncommon for warrants.
Taxes on Stock Warrants
Tax treatment is another difference between stock options and stock warrants. Stock options, in an employee compensation context, can be eligible for preferential tax treatment. But stock warrants don’t enjoy the same breaks. Exercising stock warrants results in taxable income that amounts to the difference between the strike price and the price of a share, minus the cost basis.
For example, say you exercise warrants with a strike price of $20 per share to buy 100 shares of XYZ Corp. You originally paid $400 for the warrants, so your total investment is $2,400. If the market price on the day of exercise is $40, the shares are worth $4,000. That’s a difference of $1,600. That amount is deemed to be ordinary income, not a capital gain, since you didn’t own the stock before exercising the warrants. It’s a good idea to consult a tax expert to make sure you understand and follow relevant tax rules.
Bottom Line
Stock warrants, a derivative security that is a common feature of venture capital debt, have many characteristics of stock options. Both have a strike price and an expiration date. However, there are key differences. Stock options are compensatory; warrants are often for raising capital. Stock options are available on the open market; warrant are issued by the company. Tax treatments also differ between the two.
Investing Tips
- Whether you trade in warrants, options, equities or bonds, financial advice can make all the difference. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area. And you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Given the relative complexity of how stock warrants are taxed, a free tax calculator can get you in the ball park of what is owed. Also, if you’re especially focused on lowering your tax liability, here is a helpful guide to assist you in achieving that goal.
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