Warrants are a derivative that give the right, but not the obligation, to buy or sell a security—most commonly an equity—at a certain price before expiration. The price at which the underlying security can be bought or sold is referred to as the exercise price or strike price. An American warrant can be exercised at any time on or before the expiration date, while European warrants can only be exercised on the expiration date. Warrants that give the right to buy a security are known as call warrants; those that give the right to sell a security are known as put warrants.
Warrants are in many ways similar to options, but a few key differences distinguish them. Warrants are generally issued by the company itself, not a third party, and they are traded over-the-counter more often than on an exchange. Investors cannot write warrants like they can options.
Unlike options, warrants are dilutive. When an investor exercises their warrant, they receive newly issued stock, rather than already-outstanding stock. Warrants tend to have much longer periods between issue and expiration than options, of years rather than months.
Warrants do not pay dividends or come with voting rights. Investors are attracted to warrants as a means of leveraging their positions in a security, hedging against downside (for example, by combining a put warrant with a long position in the underlying stock), or exploiting arbitrage opportunities.
Warrants are no longer common in the United States but are heavily traded in Hong Kong, Germany, and other countries.
Traditional warrants are issued in conjunction with bonds, which in turn are called warrant-linked bonds, as a sweetener that allows the issuer to offer a lower coupon rate. These warrants are often detachable, meaning that they can be separated from the bond and sold on the secondary markets before expiration. A detachable warrant can also be issued in conjunction with preferred stock.
Wedded or wedding warrants are not detachable, and the investor must surrender the bond or preferred stock the warrant is "wedded" to in order to exercise it.
Covered warrants are issued by financial institutions rather than companies, so no new stock is issued when covered warrants are exercised. Rather, the warrants are "covered" in that the issuing institution already owns the underlying shares or can somehow acquire them. The underlying securities are not limited to equity, as with other types of warrants, but may be currencies, commodities, or any number of other financial instruments.
A debt warrant is an agreement in which a lender has a right to buy equity in the future at a price established when the warrant was issued or in the next round.
Many venture debt lenders require warrants and expect roughly half of their total returns will come from warrants (and half from interest payments). If your startup does well, the warrant can be worth a lot of money to the lender. A debt warrant works similar to an incentive stock option for employees. Warrants have the potential to make the holder a large profit very quickly if the price of the company’s stock is much higher than the price at which the warrant holder is permitted to buy it.
Warrants generally trade at a premium, which is subject to time decay as the expiration date nears. As with options, warrants can be priced using the Black Scholes model. Remember warrants are rights to own stock and not immediate capital for a company. Dilution is an important consideration. Typically shareholders are only inclined to dilute their holding up to 5% of their original capital. Otherwise, holders of warrants become key investors!
References:
Derivative Warrants explained: Types and example, James Chen, Investopedia/Xiaojie Liu, 20 May 2022
What are Debt Warrants and how do they work for start-ups? Lighter Capital
