What are Share Warrants – Its Examples, taxation And Why Do Companies Issue Them?
A share warrant is a contract between an individual and an organization that allows the individual to trade the company shares at a fixed price on or before a pre-decided date. The price is called ‘strike price’, and the date before which it can be traded is called the ‘expiration date’.
Companies issue warrants in the stock market to primarily raise capital. They may also issue these warrants as employee perks. Read on to understand why companies issue share warrants, when are share warrants issues, share warrant types, their benefits and other details.
Why Do Companies Issue Warrants?
Below are some reasons why companies issue warrants:
- To Raise Capital: If a company needs funds, it can sell warrants in the open market or give them to financial institutions for resale. This generates capital both through warrant sales and stock sales when the warrants are used.
- To Finance Acquisitions: If a company wishes to buy another company, it may offer warrants along with cash to fund the purchase.
- To Encourage the Purchase of Bonds or Preferred Stocks: Companies may make bonds or preferred stocks more attractive using warrants. They may issue bonds attached with warrants to help buyers benefit from increasing share prices.
- To Allure Employees: Organizations have been using warrants for a long time to attract new employees and retain existing ones.
Share warrants are investment instruments that allow investors to buy the stocks of a company at a future date. The idea is that companies offer stock warrant shares at a price significantly lower than the current market value. However, the shares are not issued at the time when the stock warrant is presented.
The share warrant is a promise to honour the strike price mentioned on the warrant when the investor wants to exercise call rights. The investor must exercise the call right before the strike date for the company to honour and uphold the contract.
Companies must follow the conditions below to issue share warrants:
- Only public companies are permitted to issue share warrants
- The Articles of Association must authorize the issuing of share warrants
- The shares must be completely paid-up
- The Central Government must approve the issuing of share warrants
The company is mandated to strike off the member’s name in the ‘member register’ once the stock warrant is issued. They must also enter the following details:
- The fact of the issue of share warrant
- Details of shares that are included in the warrant. Each share must be distinguished by its number.
- Issue date of the warrant
A share warrant is a negotiable instrument, and the ownership of shares can be transferred only by delivery. Each warrant has attached coupons that bear the dates when the company will pay the dividend. This is because it is naturally impossible for the company to identify every shareholder. As such, a dividend will be paid to the one who produces the appropriate coupon.
Types of Stock Warrants
Put warrants, and call warrants are the two types of warrants. Using put warrants, holders can sell shares of stock that they already own. Call warrants, on the other hand, allow investors to buy shares of stock.
1. Call Warrants
A majority of warrants are call warrants. They allow the holders to buy a stock at a strike price during a timeframe that ends at the expiration date of the warrant. It is profitable for investors to exercise the call only when the stock market price is higher than the strike price.
For example, assume a call warrant has a strike price of Rs. 1100. If the market price of the stock is equal to or below Rs. 1100, the investor must let the warrant lapse. However, if the stock price climbs to Rs.1500, the investor can exercise the warrant and avail of a discount of Rs. 400 per share.
2. Put Warrants
These warrants give the right to the holder to sell a specified number of shares to the issuer. These shares are sold to the strike price. It is important to know that put warrants give just the right to sell and not any obligation. It is profitable to exercise put warrants only when the market price is lower than the strike price.
In the same example above, if the share price drops below Rs. 1100, it is beneficial to sell the shares at Rs.1100.
Examples of a Stock Warrant
Below is a stock warrant example that illustrates how warrants work. Suppose an organization wants to issue stock warrants as a part of employee benefits. Below is the possible structure of the warrants:
Take, for instance, an American-style call warrant for 1000 shares of the organization’s stock at a strike price of Rs.500 within 7 years. The expiration date is 7 years post the date of issue.
The holders of this stock’s warrant have the right but are not obliged to buy 1000 shares of the organization at Rs.500 per share, even if the stock price is Rs.750 per share. The warrant becomes more valuable as the stock price increases. The holder can profit from this right within 7 years. Post expiration date, the warrant becomes useless.
Next, assume a European-style put warrant for 1000 shares of the organization’s stock at a strike price of Rs.750 on a specific date.
This is a different type of stock warrant. It offers a right to the holder but doesn’t put them under the obligation to sell 1000 shares of the organization’s stock back to them for Rs.750 per share. So, even if the stock is only worth Rs.300, the company must buy it from the warrant holder for Rs.750 per share. The stock becomes more valuable if the stock price falls lower. This warrant can be exercised only on a specific date; it expires after the date and is not mature before the date.
Put warrants are issued rarely. This is because issuing them translates to betting against the company’s own stock. Issuing put warrants can trigger multiple ethical, legal, and cultural issues.
While issuing stock warrants, the company also sets a price per share.
The advantages of share warrants are below:
1. Substantial Long-term Returns
Warrants help investors to make long-term investment decisions. This means that investors can wait for numerous years before buying the underlying shares of the warrant. As time passes, the probability of the share price exceeding the warrant’s strike price increases. However, this depends on business fundamentals and market conditions. The long-term profits of most companies are generally higher.
2. Lower Cost as Compared to Standard Options
Share warrants are usually cheaper than regular share prices. They are an alternative to regular stocks. This can help to diversify investments. It also allows investors to profit from market situations.
3. Better Management of Capital
Warrants are classified into groups of shares. Also, they allow buying shares at a definite price across a timeframe. Investors can accumulate shares in gradual increments instead of having to buy right away.
The following are the limitations of share warrants
- There is a cap on the number of warrants and shares reserved for the warrant exercise and shares reserved for exercising existing warrants. The limit is 50% of the share capital of the company.
- The company must set the exercise price while issuing the warrant. It should foresee the time and its fund requirement.
- Companies must offer deals to attract investor interest because warrants are issued only by a few companies and are thinly traded.
- Only listed companies can issue warrants.
How are Stock Warrants Taxed?
Below are the tax implications on share warrants:
- When a Warrant is Subscribed: When a person subscribes to a warrant by paying a subscription premium, neither the company nor the subscriber has to pay a tax.
- When Subscription Premium is Forfeited: If the warrant subscriber doesn’t convert the warrant to shares before the date mentioned on the warrant, the company will forfeit the premium. In these cases, the subscriber must claim the premium amount as a capital loss. The upfront premium is the capital receipt, and there are no tax implications.
- When Warrants are Converted to Shares: In the case of conversion of warrants into shares, the subscriber must pay taxes despite not having to sell the shares.
- When the Sales are Sold: Once the underlying shares in the warrant are sold after conversion, the gain/loss attracts taxes as capital gain/loss. The share cost is the share’s fair value on the conversion date.
Final Word
Stock warrants can help to diversify a traditional portfolio. However, they are very risky, and investors must watch the market movements closely. Proper research and caution can help investors to get good returns from their investment in warrants. Consult your financial advisor before investing in any type of stock warrant.
FAQs
Ans: Companies use share warrants to fulfil their capital requirements by attracting investors. They can immediately get funds without having to issue shares right away. They can thus be at an advantage if the stock price increases in the future.
Ans: There are two types of stock warrants – call warrant and put warrant.
Ans: Warrants are high-risk investment instruments. You must watch the market carefully before deciding to invest in them. Also, the warrant needs to be kept carefully, as anyone who has access to it can convert and sell it.
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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
