Warrants and stock rights are two alternatives for companies to raise additional capital. Both give the holder the right, but not the obligation, to purchase common shares of stock directly from the company at a predetermined price for a fixed time period. Importantly, existing shareholders can do so preemptively before shares are sold to the public in an effort to preserve their ownership percentage.
Stock warrant definition
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How do warrants work?
If the issuing company’s stock price rises above the warrant’s stated price, the investor can redeem the warrant and purchase the shares at the lower price. The warrant expires if the stock never grows above the strike price, rendering it worthless. Most frequently, warrants are issued in conjunction with bonds to entice investors to buy into the security. For example: If a warrant has an agreed-upon exercise price of $30 per share and the market price of the stock grows to $42 per share, the investor can redeem the warrant certificate and purchase the shares for $30 per share, earning an immediate $12 per share gain. Unlike options, warrants cause dilution, meaning a company is obligated to issue new stock when a warrant is exercised. Therefore, when investors exercise their warrant, they receive newly issued stock directly from the company rather than already-outstanding stock. Additionally, warrants tend to have more extended periods than options between issue and expiration, often years instead of months.
Stock rights definition
A company typically issues a rights offering when it wants to raise extra capital. But, like warrants, this type of offer causes dilution, lowering the value of shares as it creates more of them. Still, it also allows investors to hold their current stake in the company if they buy more shares. They are often offered at a discount relative to the current market price. In addition, rights are often transferable, allowing the holder to sell them in the open market.
How do stock rights work?
A rights issue is effectively an invitation by the company to existing investors to purchase additional new shares by the defined expiration date. Essentially, the company is giving shareholders an opportunity to increase their exposure to the stock at a discount price. More specifically, this type of issue offers existing shareholders securities called “rights,” which they can trade on the market the same way they would with ordinary shares. As a result, the rights issued to current shareholders have value since they offer compensation for the future value dilution of their existing shares. Dilution occurs because a rights offering spreads a company’s net profit over more shares. Thus, the company’s earnings per share (EPS) decrease as the allocated earnings result in share dilution. The number of shares an investor has the right to purchase is proportional to their current slice in the company. So, if they choose to exercise their right, they’ll end up with the same percentage of ownership that they had before the additional shares were issued. On the other hand, if they decide not to purchase the shares, they’ll be left with a smaller stake in the company.
Subscription Right
A subscription right (“subscription privilege,” “preemptive right,” or “anti-dilution right”) is the right of existing shareholders in a company to retain equal percentage ownership by subscribing to new stock issuances at or below market prices. The subscription right is typically enforced by using rights offerings, which allow shareholders to exchange rights for shares of common stock at a cost below where the stock is currently trading. Recommended video: The cost of share dilution
Types of Stock Warrants
There are call and put warrants. A call warrant represents a set number of shares that can be purchased from the issuer at a determined price on or before the expiration date. A put warrant represents a certain amount of equity that can be sold back at a fixed price on or before the expiration date. The type of warrant will determine the degree of risk and value:
#1 Traditional Warrants
Traditional warrants are sold in conjunction with a bond (called warrant-linked bonds), which allows for a lower coupon rate on the bond. In addition, these warrants can often be detached from the bond and sold on the secondary market before expiration.
#2 Wedded Warrants
Wedded warrants remain attached to the bond, meaning if the holder wants to exercise the warrant and acquire their shares, the bond (the warrant is “wedded” to) must also be surrendered.
#3 Covered Warrants
Financial institutions rather than companies issue covered warrants (sometimes called naked warrants). New stock is not issued when covered warrants are exercised. Instead, the warrants are backed (covered) by the issuing institution that owns the underlying securities or can acquire them. The underlying assets are not restricted to equity, like other types of warrants, but can be currencies, commodities, or other financial instruments, making them a lot more flexible.
Types of stock rights
There are two main types of rights offerings: direct rights offering and insured/standby rights offering.
#1 Direct rights offering
In a direct rights offering, a company issues rights to its shareholders and sells only the shares they decide to buy. If some rights go unexercised, the company doesn’t sell those shares. This type of offering could result in undercapitalization (raising less capital than anticipated). As such, it is best suited for companies that want to raise money but don’t have a specific amount they need.
#2 Insured/standby rights offering
Insured/standby rights offerings, usually the more expensive type, allow third-party purchasers (such as an investment bank) to purchase unexercised rights. Here, each shareholder has the same right to buy additional shares, but the third party will buy them if they choose not to exercise their right. This type of agreement ensures the issuing company has its capital requirements met.
Similarities and differences with call options
Warrants, stock rights, and call options are all types of options that can be exercised, traded, and can expire. Let’s look at some of the primary attributes that they have in common:
Strike price or exercise price: the fixed price at which the holder has the right to purchase the underlying asset; Maturity or expiration date: the predefined time period during which the warrant, stock right, or call can be exercised; Option price or premium: the price at which the warrant, stock right, or option trades in the market. Option: all holders have the right without the obligation to exercise their option, warrant, or right.
Some significant differences between these derivatives include:
Issuer: warrants and stock rights are issued by a specific company, though a secondary market that allows other buyers to acquire these securities often emerges. In comparison, an exchange or brokerage issues exchange-traded options. As a result, warrants and rights have few standardized features, while exchange-traded options can be more standardized (expiration periods and the number of shares per option contract);
Capital: when a stock right or warrant is exercised, the company directly issues the shares of stock to the right or warrant holder. In this way, rights and warrants are a source of capital for companies. By contrast, the call premium is the fee paid by the buyer to the seller to obtain this right.
Maturity: warrants usually have more extended maturity periods than options and rights. While they generally expire in one to two years, they can sometimes have maturities well over five years. Conversely, call options have maturities ranging from a few weeks or months to about a year or two (most expire within a month). Longer-dated options are likely to be relatively illiquid. Rights, too, are short-term instruments that expire quickly, generally between 30-60 days;
Dilution: warrants and rights generate dilution because a company is bound to issue new stock when either of them is exercised. Exercising a call option, however, does not involve issuing new stock since a call option is a derivative instrument on the company’s existing share.
How to value stock rights and warrants
Like market options, rights or warrants become worthless if the stock’s market price falls below the exercise or subscription price. In addition, rights and warrants are also rendered worthless upon expiration regardless of where the underlying asset is trading. Indeed, the values for stock rights and warrants are determined similarly to market options. They all have intrinsic value, equal to the difference between the market and strike prices of the stock, and time value, based on the stock’s potential to expand in price before the expiration date.
Calculating the value of warrants
Warrants have no intrinsic value at issuance since they are delivered with an exercise price above the current market price. Instead, they are assigned a waiting period, giving the stock price time to increase enough to surpass the strike price and provide intrinsic value. To find the value of a stock warrant, you must first look up the stock’s current market price. You then subtract the exercise (subscription) price from the market price to arrive at the intrinsic value of the warrant. Finally, divide the intrinsic value by the number of shares that can be purchased with one warrant. The formula for estimating the value of a warrant: (Current price – Subscription price) / Warrants needed
Calculating the value of stock rights
Unlike warrants, stock rights have intrinsic value at issuance as they give existing shareholders so-called “rights,” which provide them with the right to purchase new shares at a discount to the market value. Similarly to warrants, to estimate the value during the exercise of rights period, you must first find out the stock’s current market price. Followed by subtracting the subscription price from the market price and dividing that by the number of rights needed to buy one new share. The formula for the value during the exercise of rights period is as follows: (Current price – Subscription price) / Rights needed Note: The theoretical value during the cum rights period differs from the exercise of rights period. The formula for the value during cum rights period: (Stock price – Subscription price) / Rights needed plus 1. Cum rights: Shares that still have rights available to them, up until three days before the subscription rights expire Exercise of rights period: when rights trade independently of the stock, period of time about three days before expiration.
Taxes for rights and warrants
Rights and warrants are taxed like any other security. Stock rights are not taxable if they are exercised. Therefore, any gain or loss is realized when the acquired stock is sold. The difference between their exercise and sale price is taxed as a long- or short-term gain. Any gain or loss obtained from trading rights or warrants in the secondary market is taxed similarly (except that all profits and losses will be short-term).
Pros and cons of stock warrants
Benefits:
Warrants offer a long-term investing perspective. As investors can wait several years before buying the shares underlying the warrant. Therefore, the potential of the market price surpassing the strike price of the warrant increases; Since warrant prices are typically low, the leverage (the use of debt to boost returns from an investment) and gearing (a measure of how much of a company’s operations are funded using debt versus the funding received from shareholders) they offer are generally high, generating potentially more significant capital gains; While it’s common for share and warrant prices to move together in absolute terms, the share gain or loss will vary significantly because of the initial price difference. Therefore, warrants tend to exaggerate the percentage change movement compared to the share price.
Drawbacks:
Because leverage and gearing that warrants offer can be high, these can also work to the investor’s hindrance, generating potentially more significant capital gains; If the value of the certificate drops to zero, and it happens before the warrant is exercised, it would lose any redemption (the repayment of a security at or before its maturity date) value; A warrant holder has no voting or dividend rights and gets no say in the company’s operations, even though they are affected by their decisions and policies.
In conclusion
Rights and warrants allow existing shareholders to purchase additional shares at a discount and keep their stake in the company. Accordingly, protecting current investors from dilution of ownership when the company issues new shares of stock. However, both types of securities will become worthless upon expiration or lose their intrinsic value if the stock’s market price drops below their exercise or subscription price. As a result, like any financial instrument, stock rights and warrants, too, should be exercised with caution, and shareholders must educate themselves about the value of their rights.
