Warrants

The Warrant as a Long-Dated Call Option — Structure and Terms

The structural mechanics of a warrant are in most respects identical to those of a call option — the warrant gives the holder the right to purchase shares at a fixed exercise price on or before a specified expiration date, with the value of the warrant derived from the same factors that determine call option value — the relationship between the current stock price and the exercise price, the time remaining to expiration, the volatility of the underlying stock, and the prevailing risk-free interest rate.

The exercise price of a warrant — also called the strike price, consistent with options terminology — is the fixed price per share at which the warrant holder can purchase the issuing company’s common stock upon exercise. The exercise price is set at the time of issuance and does not move with the market price of the stock, although it is not beyond change: the SEC staff has recognised that an issuer may reduce the exercise price, or extend the exercise period, of registered warrants by filing an appropriate prospectus supplement before the warrants expire. In most warrant issuances, the exercise price is set at or above the market price of the common stock at the time of issuance — the warrant is initially out of the money — making it a speculative instrument that becomes valuable only if the stock price subsequently rises above the exercise price.

The expiration date is the date beyond which the warrant can no longer be exercised — warrants that have not been exercised by the expiration date expire worthless. Warrant expiration periods are substantially longer than standard exchange-traded call options — while exchange-listed equity options typically expire in months and even the longest-dated LEAPS expire in two or three years, warrants routinely have expiration periods of five, seven, or ten years, with some warrants issued as perpetuals having no expiration date at all. This extended time to expiration is one of the features that makes warrants attractive as sweeteners for bond offerings — the long time horizon gives the warrant more time value and therefore more incremental value to the bond purchaser.

The intrinsic value of a warrant — like that of a call option — is the excess of the current stock price above the exercise price when the stock trades above the exercise price — calculated identically as stock price minus exercise price for any in-the-money warrant. The time value — the additional premium above intrinsic value reflecting the remaining potential for further appreciation before expiration — is generally higher for warrants than for standard call options given the much longer time horizon remaining, making warrant premiums higher than equivalent-strike call options of shorter duration.

The Dilution Distinction — Why Warrants Differ Fundamentally From Call Options

The single most examination-critical distinction between warrants and exchange-traded call options is the dilutive effect of warrant exercise. This distinction is tested directly and repeatedly on both the Series 7 and Series 65 examinations and must be understood precisely.

When an investor exercises an exchange-traded call option, the Options Clearing Corporation assigns the exercise to a short call writer who must deliver one hundred shares of the underlying stock. The short call writer delivers existing shares — shares that already exist and are already counted in the total shares outstanding. No new shares are created, the total shares outstanding does not change, and existing shareholders experience no dilution from the option exercise. The company itself is not involved in the transaction at all — the option exercise is entirely between the long call holder and the assigned short call writer, with the OCC serving as the central counterparty.

When an investor exercises a warrant, the process is fundamentally different. The warrant holder presents the warrant to the issuing corporation along with the exercise price payment. The corporation — which is the direct counterparty to the warrant contract — issues new shares of common stock to the warrant holder in exchange for the exercise price payment. These newly issued shares did not previously exist — they are drawn from the corporation’s authorised but unissued share reserve. After the exercise, the total shares outstanding has increased by the number of shares delivered to the warrant holder. This increase in total shares outstanding dilutes the ownership percentage of all existing shareholders — each existing share now represents a smaller fraction of the total company than it did before the warrant exercise.

The dilution effect of widespread warrant exercise can be substantial for warrant-heavy capital structures. A company that has issued warrants representing twenty percent of its current outstanding shares — and all warrants are subsequently exercised — will see its total shares outstanding increase by twenty percent, with each existing shareholder’s fractional ownership of the company declining by approximately sixteen and two-thirds percent from the pre-exercise level. Earnings per share, book value per share, and voting power per share all decline proportionally.

Because warrant exercise dilutes existing shareholders, the issuance of warrants — which creates the potential for future dilution — typically requires shareholder approval under the relevant exchange listing standards and the terms of the company’s articles of incorporation. This requirement protects existing shareholders from management unilaterally creating securities that will dilute their ownership without their consent.

Warrants as Sweeteners — The Bond and Preferred Stock Context

The most common practical context in which warrants are encountered in the capital markets is as sweeteners — securities attached to primary debt or equity issuances to make those primary securities more attractive to investors and thereby reduce the cost of the primary financing.

When a company issues bonds — particularly high-yield or below-investment-grade bonds where investor demand may be limited — attaching warrants to the bond offering adds incremental value that allows the company to offer a lower coupon rate on the bonds than would be required without the warrant sweetener. A company that might need to offer an eight percent coupon on a standalone bond offering might successfully place the same bonds at a seven percent coupon by attaching warrants that give bondholders the right to purchase company stock at a modest premium to the current price. The warrants represent potential upside participation in the company’s equity appreciation that compensates bondholders for accepting a below-market coupon rate.

The warrants attached to bond offerings are typically detachable — after issuance they can be separated from the bond and traded independently in the secondary market. A bondholder who receives a bond with attached warrants can choose to hold both instruments, sell only the warrant while retaining the bond, or sell only the bond while retaining the warrant — maximising flexibility in managing the combined position.

Warrants are also used in preferred stock financing — particularly in private equity and venture capital transactions — where investors who purchase preferred equity may receive warrants as an additional incentive that provides further equity upside beyond the preferred stock’s fixed return characteristics.

Warrants in SPAC Transactions — The Modern Application

Special purpose acquisition companies — SPACs — are blank-check shell companies that raise capital through an initial public offering for the purpose of subsequently merging with or acquiring a private operating company. SPACs have become a significant application context for warrants in the modern capital markets, with virtually every SPAC IPO including warrants as a component of the unit sold to public investors.

A typical SPAC IPO sells units at ten dollars per unit — each unit consisting of one share of SPAC common stock and a fraction of a warrant to purchase additional SPAC shares at an exercise price of eleven dollars and fifty cents. After the SPAC IPO the units typically separate — the shares and warrants trade independently. If the SPAC successfully completes a business combination with a target operating company, the warrants become warrants to purchase shares of the combined public company at the eleven dollar fifty cent exercise price. If the SPAC fails to complete a business combination within the specified time period — typically eighteen to twenty-four months — the SPAC liquidates and the warrants expire worthless while shareholders receive their pro-rata share of the trust account.

The SPAC warrant structure became a subject of significant SEC attention beginning in 2021, when the SEC issued guidance and comment letters indicating that SPAC warrants should in many cases be classified as liabilities — requiring fair value accounting treatment on the issuer’s balance sheet — rather than as equity instruments. This accounting classification issue affected numerous SPAC companies and required restatements of previously filed financial statements.

Why SPAC Warrants Came to Be Classified as Liabilities

In a staff statement on SPAC warrants issued on 12 April 2021, the SEC's Division of Corporation Finance and Office of the Chief Accountant explained that under US generally accepted accounting principles an equity-linked instrument must be considered indexed to the entity's own stock to qualify for equity classification, and that variables able to affect the settlement amount do not preclude that conclusion if they would be inputs to the fair value of a fixed-for-fixed forward or option on equity shares. In one fact pattern the warrants provided for potential changes to the settlement amounts dependent upon the characteristics of the holder of the warrant, and because the holder of the instrument is not an input into the pricing of such an option, the staff concluded that the provision precluded the warrants from being indexed to the entity's stock.

A second fact pattern turned on cash settlement. The same accounting principles classify a contract as an asset or a liability if an event outside the entity's control could require net cash settlement, subject to an exception where net cash settlement can be triggered only in circumstances in which the holders of the shares underlying the contract would also receive cash. The warrants in question entitled all warrant holders to receive cash in the event of a tender or exchange offer made to and accepted by holders of more than fifty percent of the outstanding shares of a single class of common stock, while only certain of the holders of the underlying shares would be entitled to cash, and the staff concluded that the provision required liability classification.

In each case the staff's conclusion was a liability measured at fair value, with changes in fair value reported each period in earnings. For a registrant that concluded its earlier financial statements contained a material error, the statement explained that the error could be corrected by amending the most recent Form 10-K and any subsequently filed Forms 10-Q to include restated financial statements, and that it should also assess whether an Item 4.02 Form 8-K reporting non-reliance on those statements was required.

The Warrant Versus the Right — The Comparison Directly Tested

Both warrants and rights are short-call-like instruments that give holders the ability to purchase common stock at a specified price — but they differ in several critical ways that are directly tested on the Series 7 and Series 65 examinations.

Rights — covered in the Rights offering entry of this dictionary — are issued to existing shareholders on a pro-rata basis, granting each shareholder the right to purchase additional shares in proportion to their current holdings. Rights are designed specifically to allow existing shareholders to maintain their proportional ownership percentage by participating in new equity offerings before those shares are sold to the public. Rights have very short expiration periods — typically two to four weeks — and are priced at a discount to the current market price, making them immediately in the money and almost always worth exercising or selling.

Warrants are issued to investors in connection with bond, preferred stock, or other financings — not necessarily to existing shareholders on a pro-rata basis. They have much longer expiration periods of years rather than weeks, are typically set at or above the current market price making them initially out of the money, and are used as sweeteners to reduce financing costs rather than as anti-dilution mechanisms for existing shareholders.

The examination comparison — rights are short-term, issued to existing shareholders proportionally, set below market price, and designed to prevent dilution of existing owners; warrants are long-term, issued to new investors as sweeteners, typically set at or above market price, and result in dilution of existing owners when exercised.

Registering the Shares Behind a Warrant

Because the shares a warrant delivers are new securities issued by the company, a registered offering of warrants raises a second registration question. The SEC staff's view is that where warrants being registered under the Securities Act are exercisable within one year, an offering of both the warrants and the underlying shares is deemed to be taking place, so the underlying shares must be registered at the same time. Where the warrants are not exercisable within one year, the issuer may choose not to register the underlying shares when it registers the warrants, but must register them no later than the date the warrants become exercisable by their terms if no exemption for the exercise is available.

Registration of the exercise is a continuing matter rather than a single event. The staff's interpretation is that an issuer whose warrants are out of the money does not have to keep the prospectus for the exercise of those warrants current, but must amend it once exercise of the warrants becomes in the money, and that no warrants may be exercised until the issuer has brought its prospectus covering the exercise current.

Form S-3, the short-form registration statement, has a transaction category of its own for these shares. Its eligibility rules treat securities to be offered upon the exercise of outstanding warrants issued by the issuer of those securities, or by an affiliate of that issuer, as a transaction separate from the primary offerings for cash that are tied to a seventy-five million dollar market value of common equity held by non-affiliates. That category is available only if the issuer has sent to all record holders of the warrants, within the twelve calendar months immediately before the registration statement is filed, material containing the annual report information required by Exchange Act Rule 14a-3(b).

Tax Treatment of Warrants

The tax treatment of warrants involves several specific considerations that investment advisers must understand when working with clients who hold warrant positions.

The purchase of a warrant is not a taxable event — the investor pays the warrant premium and receives the warrant with no immediate income recognition. The holding period for the warrant begins on the purchase date.

If the warrant is sold rather than exercised — selling the warrant in the secondary market before expiration — the gain or loss is treated as a capital gain or loss. If the warrant has been held for more than twelve months, the gain is a long-term capital gain taxed at preferential rates. If held for twelve months or less, the gain is a short-term capital gain taxed as ordinary income.

If the warrant expires worthless — the most common outcome for out-of-the-money warrants — the warrant holder recognises a capital loss equal to the original cost of the warrant in the year of expiration. The character of the loss — short-term or long-term — depends on the holding period.

If the warrant is exercised — the holder pays the exercise price and receives shares — no gain or loss is recognised on the exercise itself. Instead the cost basis of the shares received equals the exercise price paid plus the original cost of the warrant. The holding period of the new shares begins on the exercise date — not the date the warrant was purchased — for purposes of determining short-term versus long-term capital gain treatment on a future sale of the shares.

Warrant Valuation — The Theoretical Framework

Warrants are valued using the same inputs and the same theoretical framework as call options — the Black-Scholes model and its variants can be applied to warrant pricing with appropriate adjustments for the dilution effect of new share issuance upon exercise.

The primary theoretical modification required for accurate warrant valuation — compared to call option valuation — is the dilution adjustment. When a call option is exercised, the total number of shares outstanding does not change and the stock price is unaffected by the exercise. When a warrant is exercised, new shares are issued and the total shares outstanding increases, which if all else were equal would reduce the stock price per share proportionally to the dilution. This dilution effect must be incorporated into the warrant valuation model — the theoretical value of a warrant is somewhat less than the theoretical value of an otherwise identical call option because the dilution from exercise partially offsets the benefit of acquiring shares at the below-market exercise price.

In practice, for warrants representing a small percentage of total outstanding shares — less than five or ten percent — the dilution adjustment is small and warrant values are approximately equivalent to comparable call option values. For warrants representing a large fraction of outstanding shares — as can occur in SPAC transactions or restructuring situations — the dilution adjustment becomes material and the theoretical warrant value is meaningfully below the equivalent call option value.

Examination Relevance and Key Takeaways

Warrants are tested on the Series 7 and Series 65 examinations in the context of derivative securities, the comparison with exchange-traded call options, the dilution effect, and the use of warrants as sweeteners in bond and preferred stock offerings.

The key points to retain are these.

A warrant is a security issued directly by a corporation granting the holder the right — but not the obligation — to purchase the company’s common stock at a specified exercise price during a defined period typically extending for several years. Warrants are structurally similar to long-dated call options — the same exercise price, time to expiration, and intrinsic value concepts apply — but differ fundamentally in three critical ways that are directly examined.

First and most important — when a warrant is exercised, the corporation issues new shares of common stock, increasing total shares outstanding and diluting existing shareholders’ ownership percentage. When a call option is exercised, existing shares are transferred between investors — no new shares are created, no dilution occurs, and the company is not involved. Second — warrants have much longer expiration periods than standard exchange-traded call options, typically five to ten years compared to months for standard options and two to three years for the longest LEAPS. Third — warrants are issued by the corporation itself as a financing tool while call options are created by options exchanges and traded between investors.

Warrants are most commonly issued as sweeteners attached to bond or preferred stock offerings — allowing the issuer to obtain lower coupon rates by providing bondholders with equity upside through the attached warrant. Detachable warrants can be separated from the host security and traded independently in the secondary market. The comparison with rights — both give holders the right to purchase common stock at a fixed price — but rights are issued to existing shareholders proportionally, expire in two to four weeks, are priced below market to enable anti-dilution participation, while warrants are issued as sweeteners to new investors, expire in years, and are typically initially out of the money. Warrant exercise requires shareholder approval because it dilutes existing shareholders — call option exercise requires no shareholder approval because no new shares are created. The cost basis of shares received upon warrant exercise equals the exercise price plus the original cost of the warrant — the holding period for the new shares begins on the exercise date.