Understanding Equity Warrants: US, UK, and AU Perspective

Exploring the world of corporate finance? You'll want to get familiar with the broad range of financial instruments at your disposal. One such instrument is equity warrants (sometimes referred to as "share warrants"), which can be thought of as a ticket to buy or sell company stock under a set of conditions. 

Warrants traded on stock exchanges have certain characteristics, but in this article, we'll explore what equity warrants are in a private company context, the different kinds you might run into, and how they play a role across companies in the US, UK, and Australia.

We’ll answer:

• What are equity warrants?
• Types of equity warrants
• Are warrants debt or equity?
• How do equity warrants work?
• Key features of equity warrants
• Conversion of warrants into equity shares

Let's start with the basics.

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What are equity warrants?

Equity warrants are financial instruments that act as a contract, granting investors the right, but not the obligation, to purchase a company's stock at a specified price (known as the exercise or strike price) before the warrant's expiration date. This characteristic makes warrants quite similar to options, with a few key differences. Unlike options, which are typically traded between investors on exchanges, equity warrants are issued directly by a company.

Issued often to attract investment, companies can attach equity warrants to other types of securities as further incentive for investment. This gives companies a means of leveraging capital without diluting existing shareholders' interests until they are exercised. A company only issues new shares and increases its total shares outstanding when you, as an investor, exercise a traditional equity warrant. 

Because warrants typically trade at a fraction of the underlying share price, investors can use them to gain leverage: with a relatively small cash outlay, a warrant holder can participate in any future rise in the stock’s value. However, just like any investment, there are risks. If the stock price doesn't go higher than the warrant's strike price before it expires, the warrant becomes useless, and investors can lose out on their investment.

Types of equity warrants

Equity warrants can come in various types, each serving distinct strategic purposes for companies and investors alike. Here's a closer look at some of the most common types: 

• Traditional Warrants: These are typically issued by the company as part of a capital raising exercise and give the holder the right to purchase a specific number of shares at a predetermined price, often over a long-term period. Traditional warrants are commonly attached to bonds or preferred stock as a sweetener for investors.
  
  
• Naked Warrants: Unlike traditional warrants, naked warrants (sometimes called “detachable warrants”) are issued by the company without being bundled with another security. They can be purchased independently, providing a direct opportunity to buy shares at a future date.
  
  
• Wedded Warrants: Issued in conjunction with other securities, wedded (or “non-detachable”) warrants cannot be traded separately. They are permanently bundled with another security and cannot be separated for individual trading. They are often part of a unit that includes both the warrant and its accompanying security, such as a bond or preferred share, which must be held together.
  
  
• Covered Warrants: These are issued by financial institutions and not the company itself. Similar to options, covered warrants are typically backed by shares the institution holds, adding a layer of security for investors. They provide investors with a way to bet on the rise or fall of a company's share price, without needing to own the underlying shares.

Understanding the nuances of each type is key here, particularly when it comes to making an informed decision that will balance company-specific investment strategies against your risk appetite. Whether you’re an entrepreneur looking to attract strategic partnerships or an investor seeking diversified exposure, equity warrants can offer tailored solutions for a variety of financial goals.

Are warrants debt or equity?

Warrants, by themselves, don't fit squarely into the category of debt or equity. Instead, they function as a derivative instrument. Equity warrants provide the holder with the option, but not the obligation, to purchase equity at a specified price, known as the exercise price, before expiration. 

In accounting terms, warrants are considered a potential equity instrument because they can eventually convert into shares. However, how they are reported on the balance sheet depends on their structure. If they meet certain criteria (e.g., fixed-for-fixed terms and equity settlement), they may be classified as equity; otherwise, they may be recorded as liabilities and marked to market.Warrants do not carry characteristics typical of debt, such as fixed interest payments, nor do they convey shareholder rights like voting or dividends until they are exercised.

While warrants can ultimately lead to equity ownership, they remain a distinct component  of a company's capital structure until exercised. This flexibility allows businesses to use warrants strategically, often alongside debt instruments such as bonds, to attract investment without immediate dilution of current shareholder value.

How do equity warrants work?

In practice, here's how equity warrants typically play out: when a company decides to issue warrants, it provides investors with the right to purchase the company's stock at a specific exercise price. This is usually set at or above the market price at the time of the issuance, giving the warrant value only if the company’s share price increases over time. It's worth noting that although you might hold a warrant, exercising it is optional. In other words, you are not obligated to buy the stock. 

Timing is also a central element here. Warrants come with an expiration date, after which the right to purchase the stock at the exercise price disappears. If the market price exceeds the exercise price before this date, you may want to exercise the warrant to capitalize on the potential upside. On the other hand, if the market price is below, you might decide against exercising it, as purchasing the stock would result in a loss. 

The leverage factor is another significant aspect that appeals to many investors. Warrants can exponentially heighten your investment's return potential with a relatively small upfront cost. However, it's not all upside; the potential for total loss exists if the conditions for a profitable exercise are unmet by the expiration date. 

Remember, warrants are usually issued directly by the company, unlike options that are exchange-traded. This means that when exercised, they don't impact existing shareholders directly by drawing from the pool of outstanding shares. Instead, warrants are dilutive by nature because their exercise results in the issuance of new shares, potentially affecting the value of shares held by current shareholders.

Key features of equity warrants

Let’s take a closer look at some of the critical features of equity warrants: 

• Strike Price: The price at which the warrant holder can purchase the underlying shares, often set at a premium to the current market price, though this may vary depending on the company’s objectives. This price remains fixed for the duration of the warrant's life, providing predictability for potential investors.
  
  
• Expiration Date: Equity warrants come with a set expiration date, after which the warrant can no longer be exercised. This finite period encourages warrant holders to make informed decisions about when to convert their warrants into equity.
  
  
• Leverage and Investment Potential: Warrants provide investors with the ability to leverage their investment, allowing them to control a larger amount of stock with a smaller initial input. This can amplify potential returns, though it underlines the importance of a thorough risk assessment.
  
  
• Company-Issued: Unlike options that are traded on exchanges, warrants are directly issued by the company. This makes them highly customizable, as terms can be tailored to meet the needs of both the issuing company and its investors.
  
  
• Subscription Rights: Warrants give holders the right to subscribe (i.e., purchase) a specific number of newly issued shares upon exercise. This advantage can be particularly beneficial in times of market volatility.

Conversion of warrants into equity shares

Converting warrants into equity shares involves a few key steps. First, the warrant holder must decide to exercise the warrant. This decision often depends on whether the exercise price of the warrant is attractive compared to the market value of the shares. Once the decision is made, the holder provides formal notice of exercise of the warrant, often accompanied by the payment of the exercise price. 

On receipt of the exercise notice and the applicable funds, the issuing company will then allot and issue the corresponding number of equity shares to the warrant holder. These shares are usually referred to as "Warrant Shares." The company typically issues a share certificate to the warrant holder, who is also recorded in the company's register as the official holder of these shares. This ensures that all legal rights associated with the shares are transferred to the new shareholder. 

It's important to note that once warrants are converted to equity shares, the holder becomes subject to the rights and obligations of a shareholder. These may include voting rights, receipt of dividends (if declared), and participation in any future share distributions. However, while the conversion increases the number of shares outstanding, it may lead to a dilution of existing shareholders' percentages of ownership, albeit potentially increasing the company's capital base. 

Understanding the terms of the warrant agreement is crucial, as they dictate the specific conditions and timelines for conversion. Companies may also stipulate certain events or windows when conversion is allowed, affecting strategic decisions around using or holding onto warrants.

How equity warrants function globally

Equity warrants, while sharing common underlying principles, can operate with some degree of nuance depending on the region. Below, we look at their use in the US, the UK, and Australia, and how these instruments vary from district to district. 

Equity warrants in the US

In the United States, equity warrants are less prevalent in comparison to other financial instruments like options. However, they still serve specific roles, particularly in private placements, venture financing, debt offerings, and merger transactions. Warrants are often used as “sweeteners” to enhance the appeal of a deal.

The rules governing these warrants can be complex, often involving intricate compliance and regulatory requirements, and they are less frequently traded on exchanges compared to Hong Kong or Germany. 

Equity warrants in the UK

In the UK, warrants are used by both public and private companies as a strategy for raising capital.  

Warrants offer flexibility in structuring investment terms, including exercise price, duration, and conversion mechanics. This adaptability can make them attractive for companies seeking to tailor funding solutions to investor appetite.

The regulatory framework in the UK provides safeguards to ensure that the issuance and use of warrants comply with legal and corporate governance standards. While warrants are less common than other forms of equity-based instruments, they remain a legitimate and effective financing mechanism, particularly in venture capital and growth-stage fundraising.

Equity warrants in Australia

Over in Australia, warrants play a more prominent role in retail and institutional investing compared to markets like the United States. The Australian Securities Exchange (ASX) offers a well-developed platform for trading various warrant types such as equity warrants, structured investment warrants, and instalment warrants, making them relatively more popular in the local financial landscape. 

They are valued for their potential higher leverage opportunities and are commonly employed in strategies for portfolio diversification, speculative investments, and hedging. Australian markets often refer to these derivatives simply as 'warrants,' with a strong focus on their benefits in personal investment strategies and financial planning. 

Support with equity warrants

Understanding equity warrants can transform your financial strategy by offering more dynamic investment opportunities across different markets. With their ability to provide leverage, hedge risks, or tap into strong future gains, equity warrants can be a powerful tool in both individual and corporate finance. Despite this, there are risks that go hand in hand with this type of funding, which is why it's always recommended to work with an experienced finance lawyer.

Considering equity warrants or simply exploring your funding options? Get in touch today to see how we can support you.