What are Warrants and what is a Bond/Warrant?

PURE Asset Management

September 2023

What is a warrant?

A warrant is much like an option. Both are financial instrument that grant the holder the right, but not the obligation, to buy a specific underlying asset (such as a share) at a specific price (strike price) on or before a specified date (expiration date).

Options are more common instruments and are used for a variety of purposes such as employee incentive programmes, or in lieu of fees to a third party.

In smaller companies they can be offered as part of an equity raise, as an incentive for investors to participate. The terms and conditions of company-issued options are typically determined by the issuer Company.

The key difference is that warrants are usually negotiated between the Company and the incoming investor, be they debt or equity providers. As a bilateral negotiation the terms can vary widely, whereas options tend to be more standardised.

What are the main differences between warrants and options?

Warrants and options issued by a Company as an investor incentive are similar to warrants, with the key differences being:

1. Warrants are negotiated with the investor, but option terms are determined by the Company, typically without consultation.
2. Warrants tend to have a longer life until expiry than options, which can be up to several years. Options typically have expiration dates of 6-18 months.
3. Warrants often have strike prices that are at a higher premium to the current market price of the underlying shares.
4. Warrants are typically priced based on several factors, such as the underlying asset's price, the strike price, the expiration date, and the issuer's creditworthiness. Options, on the other hand, are typically priced based on the volatility of the underlying asset and the time until expiration.
5. Options are sometimes listed on the exchange, offering the holder the opportunity to sell the option, whereas warrants are normally unlisted, and although tradable, this happens rarely.
6. During negotiation with the Company a warrant holder can include more sophisticated clauses to protect the owner from dilution, or the loss of value in the event of a takeover.

What are the attractions of warrants/options?

Primarily the attraction of a warrant or option is leverage to the underlying share price.  The value of a warrant/option, in its simplest terms, if made up of two components:

• Intrinsic value - if the share price is above the strike price, intrinsic value is the difference between the strike price (the cost of exercising) and the share price (the value the investor receives when exercised. If the share price is below the share price there is no intrinsic value.
• Time value - this is a mathematical formula (typically a Black & Scholes model) that tries to value the potential for future profit. This component tries to value the probability by reference to how long the warrant/option has to run before expiry (the longer the better); how much the share price needs to increase before it rises above the strike price; and the likelihood of that happening, which is a function of the volatility of the share price.

What this all means is that although a warrant/option may not have intrinsic value, it can still be valuable if the potential of future profit remains high. The longer the time frame until expiry; the smaller the gap between the strike price and the share price; and the higher the volatility of that share price, are all positive attributes. And vice versa.

The appeal of warrants or options is that the holder may not have paid to acquire them or may have paid very little for this future potential profit. Over time, if the share price rises above the strike price, the investor will enjoy the opportunity of exercising and converting into shares for a profit, which may be far greater than the price paid to acquire the instrument.

For example:

A share price is trading a $2.00 and the warrant/option was acquired for $0.10, with a strike price of $2.50, with a two-year life. At the time of issue, the only value is time value. This value will rise as the share price moves closer to the strike price, but this increased value will be offset be the decline in the time that is left to exercise.

If after two years, the share price is $3.00, and the investor exercises the warrant/option and immediately sells the shares, they will be able to realise a $0.40 profit. This is calculated as follows:

The appeal is that, compared to simply investing the shares, there is much more leverage to the rising share price. Using the same example above, but instead buying the shares, the investor would have made a 50% return.

Therefore, although the investor is taking more risk by buying a warrant or option, because of the limited time frame until expiry, they can achieve the same profit while deploying far less capital. See below, where both scenarios yield a $5,000 profit, but the investor in the warrant/option has had to invest just 12.5% of the capital to achieve the same outcome:

What is a Bond/Warrant?

A bond/warrant is Convertible Loan broken into its two constituent parts, being a bond (or loan to a Company), with a detached Warrant (an option to buy the shares).

Just like a convertible loan, when the warrants are exercised, the investor is effectively converting from debt into equity. This is achieved by making the cost of exercising the warrant the same as the value of the loan, so that when the Company receives the proceeds from exercise, they can be used to extinguish the loan. In turn, the investor has effectively cancelled the loan, in exchange for shares from the Company.

Just like a convertible loan, the attraction to the investor is that they prior to conversion they receive the benefits of a loan structure: interest and more protection in the capital structure, but they also have the opportunity to make an additional profit if the share price rises above the strike or conversion price.

Often a traditional convertible note does not allow the flexibility of early repayment because when the loan is repaid the investor loses the optionality of converting into shares. Convertible notes often prohibit early repayment because issuer Companies may be incentivised to repay or refinance the convertible note, just before the investor can profit from the rising share price.

Therefore, a bond/warrant structure can be attractive to the Company versus a traditional convertible loan as the Company retains the right to repay the bond whenever it chooses. Likewise, the investor is happy because if the loan is repaid early, they retain the warrant and keep the optionality to make a profit from the rising share price, but without any capital at risk i.e., they have created a free warrant.

Bond/warrants are a win-win for both the investor and the Company, but they are also a win for other shareholders. This is because the inherent attraction of the structure means the warrant strike price can justify at a material premium to the prevailing share price, therefore shareholders are less diluted, compared to raising capital via the issuance of shares. It's a win-win-win!

Funds operated by this manager:

PURE Income & Growth Fund, PURE Resources Fund