Understanding Warrant Agreements: Essential Insights and Legal Context

The Warrant Agreement – What is it?

Understanding the basic definition and life cycle of a warrant agreement is key to making sure you know what’s involved when you enter into an agreement of this nature. A warrant agreement in essence gives a security holder the ability to purchase additional securities of a company at a specified price for a certain period of time.
Warrant agreements go hand in hand with many types of preferred stock financings and other forms of capital raising activities. They are an integral part of many financing strategies used by investors and companies, especially for early stage companies as a way to assure a good return on their investment by giving them the ability to purchase securities under a warrant agreement .
A warrant agreement is similar to a stock option in that the holder gets the right but not the obligation to purchase shares at a specified price over the life of a company. Warrant agreements have a number of important uses in legal and financial transactions including:
It is important to note that laws and rules governing the scope of these instrument varies from one country to the next and often times at the state level so it is important to review the transaction with a professional that understands the scope of those laws as they apply to your specific transaction.

Types of Warrants in the Market

Warrants can be either "stock" or "equity" warrants. Stock warrants confer the right to purchase a company’s common stock (or, in some cases, other stock), while equity warrants include the right to purchase the company’s common or preferred stock (plus, in some cases, other stock or ratio shares). Companies enjoy certain accounting benefits from issuing equity warrants compared to stock warrants. They will often issue equity over stock warrants even when offering investors the option to purchase only common stock.
A "public" warrant is one that is offered to the public, while a "private" warrant is one that is not (and is generally issued as part of some other type of security).
We often hear the term "put" warrant or "call" warrant. These are simply shorter terms for a stock or equity warrant that also includes a "put" or "call" option (i.e., the right to sell or buy the underlying stock/Equity), respectively. We also sometimes hear the term "unit" warrant or "P.U." (or "PUT") warrant, which is short for "plan unit" warrant. This label refers to the practice of bundling a common or preferred stock with a put or call warrant into a new security product that is marketed to investors.
A "dow" warrant is an alternative name for a "coverage" warrant. Coverage warrants are sold separate from a mortgage bond in order to pay a premium due on the bond. A coverage warrant entitles the holder to the difference between the market value of the bond when the holder exercises the warrant and the amount already paid on the bond up to that point. The benefit to the holder is that additional issuance on the bond is not dependant on the selling price of the bond at issue.

A Warrant Agreement – Main Terms

A warrant agreement is a complex arrangement that usually contains several key components. Among these are the purchase price, expiration date and the rights and obligations of the parties involved.
Purchase Price
As with any other kind of contract, negotiation can be an important part of establishing the terms of a warrant agreement. One of the issues that will need to be discussed and agreed upon is the purchase price of the securities to be acquired if the warrants are exercised. The purchase price should be stated explicitly in the agreement. The standard practice for private placements is that the purchase price equals the price at which the securities being acquired are being sold to the public (i.e. the public place).
Expiration Date
Like the exercise price, the expiration date is another important piece of information that must be clearly stated in the agreement. Without a specified expiration date, a warrant agreement is essentially useless and certain to end up in litigation.
Rights and Obligations of the Parties
Finally, a warrant agreement will lay out the rights and obligations of the parties involved. For instance, if the corporation granting the warrants wishes to limit their future liability, the grantor can include statements indicating that the total value of the granted warrants is limited and/or that the granting of the warrants allows the corporation to redeem them for cancellation at any time in order to mitigate further losses from other stockholders.

Impact of a Warrant Agreement on Investors

For investors, warrant agreements can influence the risk and return of a portfolio in both obvious and subtle ways. As such, they can help investors with a variety of specific objectives.
A preeminent use of warrant agreements with publicly traded companies is to effectively stretch equity capital by putting additional money into play without any immediate dilution of equity ownership. In this context, a warrant agreement isn’t a traditional method of increasing equity ownership in the company; rather it’s an alternative to the much-maligned "poison pill" defense against hostile takeovers. They’re effective because they’re a low-cost and flexible vehicle for new capital that can be tied to a specific transaction, contingency, or date.
Investors may find the speculative "lottery ticket" use of warrants to be particularly appealing. Because the payoff for an investment in a company with a warrant agreement will be greater if the company’s stock price increases significantly, they can be used as a bet on a significant near-term increase in the company’s value or price per share. In some situations, these arrangements may represent a more effective mechanism than other forms of a speculative investment for an investor seeking high returns but also closely monitoring company fundamentals.
Finally, these agreements may also be appealing to certain public shareholders because they tend to have an extended term. For a company that knows it may need to consider a secondary offering in the future, these agreements can be a way to extend the time during which shareholders can choose whether to dilute their stake by participating in the offering or not, or at least remove some uncertainty regarding their dilution.

Warrant Agreement – The Legal Aspects

The assumptions and representations contained in warrant agreements must comply with federal securities regulations. All warrant purchases are considered to be equity, except for a few limited exemptions. ISSUES AFFECTING OFFERINGS: Amount of the offering, number of purchasers, and any omission of information or requirement of public knowledge should be described in the warrant agreement. While warrants are not an exemption from securities requirements, the transaction cannot exceed the exemption amount or be actively offered to more than 35 members of the company. The terms and conditions of the agreement must conform to statutory requirements under the Securities Act of 1933 and the Securities and Exchange Act of 1934 as well as state laws. All federal and state laws and regulations as well as any requirements under an exchange listing must be complied with and govern the terms and conditions of the warrant agreement . In addition, the company must determine if the securities purchased will be registered. They may be registered with Form 424b and Form SB-2. It is important to have the warrant agreement approved by the company’s bylaws, articles, and board of directors.
The enforcement of the warrant agreement may also entail litigation or arbitration. It should state if it authorizes arbitration or litigation if applicable.
The agreement should declare that the warrant holder is considered to be essentially at risk. Because the decision to invest should be made by the warrant holder, the risks associated with the investment should be discussed in detail. A material risk section can help limit the liability of the company if carefully worded. Since warrant holders assume many risks, it is important to note that the price of the stock or percentage of ownership secured through the agreement should not be entered into the company’s books. If warrants are exercised, the shares should be entered and recorded.

A Warrant Agreement – How to Draft It

It is critical, as with any contract that is being negotiated, to thoroughly understand the business terms of the Warrant Agreement before drafting or going out for negotiation. As many warrants will have a life of seven to ten years, it is important to make sure the Warrant Agreement aligns with and accurately captures the economic deal of the transaction. It is often very difficult (if not impossible) to go back and renegotiate the deal if it was not captured accurately at the outset. After that, the remaining critical step is to ensure the Warrant Agreement includes the following terms:
Fair market value – in order to avoid additional taxable income resulting from a warrant exercise, the fair market value needs to be determined by an independent appraisal or based on the price a third party purchaser (not an affiliate of the company) is willing to pay for the warrant as determined under applicable federal tax regulations.
Exercise provisions – state explicitly the notice provision for exercise of the warrant or the payment details for payment of the exercise price, the currency of payment, the installment language, and the alternative arrangements the company can make with respect to payment of the exercise price (in lieu of cash payment).
Assignment of the Warrant – is it assignable? If so, what are the restrictions on assignment of the Warrant?
Notice of assignment and change of address – as it is often a requirement to send a formal notice to exercise the option and provide a new address in case the holder moves, make sure that the address for notice, and/or the allowed method of notice and the process for change of address is clearly stated in the Warrant Agreement.
Method of exercising the Warrant – does it provide for an alternative arrangement for payment of the exercise price (e.g., withholding of shares equal to the exercise price)? Also, how should the holder exercise its Warrant – by giving a written demand to the company or by providing a signed copy of the Warrant Agreement?
Registration – do you provide for a registration rights agreement and the right of the holder of a Warrant to register the Warrant and/or the shares underlying the Warrant? Do you continue to allow the holder to maintain the right to register the shares, and not allow the company to deregister the shares pending registration? This could be a sensitive point, as companies often need to deregister securities that have been registered on Form S-1, etc., in order to prepare for a follow-on offering by way of registration of additional securities that would include those securities underlying the Warrant. Therefore, if the holder does not maintain the right to register them, dropping them from a registration statement could be problematic.
Listing – are the shares listed on a national exchange (so-called "listed") or quoted on the over-the-counter market (e.g., on the NASDAQ or OTC Bulletin Board), which may get restated in the Warrant Agreement.
Compliance with the law – are there state or federal securities law issues due to the size of the transaction or the parties involved (accredited investors or institutional investors) or other similar issuers.
Common state law issues include the investment adviser laws (the issuer should not have any contractual obligation to pay a fee to an investment adviser), state investment company or bank laws (the issuer should strive to have the investor take the receipt of the Warrant as passive, in order to avoid the risk of being deemed an investment company or bank).
Available to accredited investors; in order to fall within the safe harbors under federal law, the investor must be accredited or sophisticated; whereas other states may have similar definitions based on the investor being an "accredited investor" or "institutional buyer."
Negotiating points – be prepared to negotiate the right of first refusal, piggy-back registration rights, transferability, call provisions, etc.

Warrant Agreement – Recent Trends and Developments

The significant developments, and market conditions have led to a number of changes, and emerging trends in the use of warrant agreements. Of particular note, the attractive pricing of warrants in the secondary market has lead to their continued utility among market participants as a viable financing tool. As a result of this attractive pricing, institutional investors may assume the role of lenders, or service providers, and forgo the right to receive any securities at the time when or if certain conditions are met. In addition, as warrants often carry anti-dilution protection, they can be a more desirable solution for institutional investors in times of heightened volatility. These changes and trends, along with their related implications, are discussed below.
It is now a well-established market practice for brokers, such as Liquidnet, to distribute warrants to institutional investors at the time of their issuance, generally regardless of whether or not the warrants are supporting a private placement, public offering, or otherwise. Such broker-facilitated distributions often occur after the fact, i.e. after the warrants have been issued and executed on, and may be facilitated by way of an "offer to purchase", or "screener . " The screws, which usually allow transactions to bypass the associated transfer requirements and limitations, are also subject to a limited secondary market. Once the warrants are acquired, the investors are able to trade them in the open market. Financial advisers have also noted that warrants can typically be placed with accounts that are not subject to "40 Act" restrictions. While warrants typically accompany new issues, they are also being issued in secondary transactions, as finding an attractive price is now becoming easier. Electronic trading platforms have become critical in order to highlight discrepancies in prices in the secondary market, and consequently facilitate volume and spread when placing warrants.
Another emerging trend related to warrant agreements is the contingent contract market. Contingent contracts are, essentially, contracts that are initiated using the same mechanics as a traditional forward contract in order to settle on a predetermined date in the future, or contingent upon a condition – typically, trading performance. Contingent contracts are available on both a distressed and non-distressed basis, and are expected to play a significant role in the current environment as the market begins to stabilize.