Making the move from private to public business status is a big jump into the big leagues. It’s not a decision to take lightly, nor is it made in flippant haste. The reasons for making the jump into the public market vary widely. At the core of the motivation to go public is the opportunity to either cash-out of a long-standing investment or raise capital in a public offering. A big roadblock to raising said capital is having the investors committed at both the pre-incorporation and pre-IPO phase. In attempting to provide greater incentive and mutual benefit to both investors and existing management/shareholders, an alternative public offering can be creatively structured to include warrants as a means of providing kick-back to investors while simultaneously providing a good capital source for the company.
What is a Stock Warrant?
In it’s most simple form a warrant is a contract that gives the investor an option to purchase equity in the company at some future time based on specific terms. To be more clear, an investor may purchase say 10,000 shares today at a given price with an option to purchase more shares at a pre-determined price after a certain time period as long as the price is above a certain threshold. Each initial share of stock sold to the investor in a pre-IPO scenario may come with one or more included warrants, giving the share owner the option to purchase more stock later at a specific price.
How Does it Work?
Let’s get more specific. If a company is preparing for a public offering in the pre-Inc phase and wishes to attract more investors to invest before the offering goes public, then the firm may include, say, four warrants to each purchased share of stock. If we use our previous total of 10,000 shares with a pre-Inc price of $0.10 and a warrant option at $0.50, then here is how things may play out if the stock price reaches $1.
To the Investor
Once the new public stock begins trading, the investor has the option to buy more shares if the value of each share reaches $0.50 or more. Anything greater than $0.50 equates to direct profit to the investor. Because each of the 10,000 shares included four warrants, there exists the option to purchase an additional 40,000 shares at a mere $0.50 and sell them at the going market rate–which in this case we’ve ruled to be $1. The difference between the warrant price of $0.50 and the market price of $1 is $0.50. Multiply the $0.50 net with the additional 40,000 shares sold and the investor reaps a cool $20,000.
If each investor also sells his/her initial investment of 10,000 shares purchased at $0.10 for $1, the investors net from the sale of the pre-Inc shares amounts to $9,000 (or 10,000 x $0.90). If done in this way, the investor gleans $29,000 plus the initial principal of $1,000.
To the Company
The previously described scenario is also a boon from the company’s perspective as well. When the 40,000 warrant shares are sold to investors at a price of $0.50, the company also raises $20,000 from each individual investor in the deal. To compute the amount raised in the offering of securities simply multiply this $20,000 by the total number of investors. If there are 100 investors, then the company reaps $2,000,000 from the sale of warrants from their existing pre-Inc investors in the public offering.
There are many moving cogs in this scenario. How much capital is raised is dependent on how the warrants are structured, the success of the market maker and whether the stock goes high enough above the warrant price to incent the investors to exercise their warrants.
A warrant works very well for companies that may be experiencing high growth, but whose future is yet uncertain. Investors may wish to participate in the potential upside or the public offering itself, but may want to assuage their risk today by purchasing at a low basis. Instead, the investor can monitor the stock’s progress and choose to invest further based on the price of the stock and their own warrant exercise price. In many public offering scenarios, investors will often desire warrants to ensure they can participate further if the stock performs well.
When executed properly a warrant structure in a public offering can provide needed growth and working capital to the business as it moves from private to public status. In short, it’s a equity financing mechanism that benefits both the company and the investors who intend to bet on the company’s future but who like to avoid excessive risk in any given deal.