Many companies selling shares under Regulation A or Regulation D offer not shares alone, but units. And often, that unit is a mix of shares and warrants. Most commonly, a share-warrant unit will be one share of the company’s stock and a warrant to buy ½ of a share at a different, higher price.
What is an investor to make of these units? Those warrants can increase your returns if the investment is successful, and they pose no risk to you. Warrants generally expire, and that expiration date can be extremely important to judge how valuable the warrant might be.
What is a warrant? It’s similar to an option. It grants the holder the right, but not the requirement, to purchase shares in the future. When exercised, the money goes to the company. If the warrant is not exercised prior to the expiration date, it expires.
Here’s an example of what a unit might look like. You purchase the units of a company at $1.00 each. The Units consist of 1 share of the company’s common stock and ½ of a warrant to purchase another share for $1.50 at any time for 18 months following the beginning of the company’s offering. So if you purchase 10,000 units on the day the company begins its offering, you own 10,000 shares of the company, and warrants to purchase 5,000 shares at $1.50 for the next 18 months.
If the company has an exit event before the warrants expire, it can be very lucrative for the holder. Suppose our company goes public at $3.00 per share and the stock continues to trade there. If you had just purchased $10,000 worth of shares, you’d be pretty happy since you would own a stock trading at three times your investment, or $30,000. But with the warrants, you can purchase an additional 5,000 shares of stock for $1.50 each, or $7,500. And since the shares are trading at $3.00, the shares you just purchased are worth $5,000. That gives you an additional profit of $7,500, for a total position of $37,500 on your $10,000 investment.
The same thing is true if the company sells. If the company sells to a competitor at that same $3.00 share, you have the right to exercise your warrants for $1.50 each and sell the resulting shares directly into that competitor’s offering. So you see the same profit as if you had sold your investment following an IPO.
That sounds pretty good, yes? An extra $7,500 on top of the money you made from the stock you purchased? It is pretty good, and that’s why investors like warrants so much. However, those warrant profits are not guaranteed. There are several things that have to happen in order for warrants to have value.
First, of course, the company must succeed. It must either have an exit event like an IPO or sale, and the valuation must be higher than the exercise price of the warrants. As an alternative, the company may convince you to purchase the shares at a higher price in anticipation of such an exit event. An example of the latter might be if the company starts offering shares at a higher price. At Deal Report we have previously mentioned why it might be good to purchase shares at higher prices. If our company starts a new Regulation A raise at $3.00, you can still exercise your warrants and buy more of the company at the lower price of $1.50. The difference between doing that and exercising in an exit event is that you cannot sell the new shares. If you decide you want to continue to invest in the company’s growth, the warrants have decreased your cost of scaling into the company but you still must wait for an exit event to potentially profit.
Second, the warrants must be exercised before they expire. Do not underestimate the limitation that the expiration date represents. If our hypothetical company goes public after the warrants expire, you cannot exercise the warrants. Similarly, if the warrant exercise price is higher than the offering price, which is to say, an investor could have bought units at the offering price instead of exercising warrants for a higher price at any time during the company’s offering, that is not a valuable warrant.
Your checklist item: Warrants can increase your profits in a successful offering, but you should never invest in a company solely because it is offering warrants. Consider warrants a sweetener. Take note of the exercise price and the expiration date, because those are what determine how likely an exercised warrant will translate into a successful investment.
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