Warrant coverage is an agreement between a company and its shareholders where the company issues a warrant equal to a specific percentage of the dollar amount invested. Warrants, similar to options, allow investors to acquire shares at a designated price.
Warrant coverage agreements are designed to sweeten the deal for an investor because the agreement leverages their investment and enhances their return if the company’s value increases as expected.
Key Takeaways
- Warrant coverage grants shareholders the opportunity to gain additional shares as a perk of owning a part of the company.
- It comes in the form of an agreement stating that investors will be issued warrants.
- Warrants function much like options, except they are issued by the company and dilute overall equity ownership.
Understanding Warrant Coverage
Warrant coverage ensures investors that they can increase their share ownership in the company if circumstances improve significantly. This is achieved by issuing warrants as a condition of the investors’ participation.
A warrant is a type of derivative that gives the holder the right to buy the underlying stock at a specified price before or at maturity. The warrant does not obligate the holder to purchase the underlying stock. Warrant coverage is essentially the agreement to issue shares to cover the potential future execution of the warrant.
Warrants are similar to options but differ in three main aspects. First, they originate from the company itself, not from traders. Second, warrants are dilutive to the underlying stock as the company issues new stock when the warrant is exercised, unlike delivering existing stock. Finally, they can be attached to other securities, most notably bonds, granting the holder the right to purchase shares of stock as well.
Reasons for Warrant Coverage
Warrant coverage encourages holders to participate in the company’s success, reflected in the appreciation of the underlying stock’s price. It also provides protection against the dilutive effects of any future share offerings. Although the exercise of the warrant is itself dilutive to the existing shares, it provides an ironic form of future protection.
Companies might issue warrants to attract more capital, particularly if they find it challenging to issue bonds at a satisfactory rate or amount. Warrants attached to a bond can make them more appealing to investors, often being seen as speculative.
One exemplary case of warrant coverage occurred during the 2008 financial crisis. Goldman Sachs, in need of increasing capital and elevating financial health perception, sold $5 billion of preferred stock to Warren Buffett’s Berkshire Hathaway, Inc., alongside the warrants to purchase $5 billion of common stock with a strike price of $115 per share and a five-year maturity. This was profitable for Berkshire as Goldman’s shares were priced near $129 at that time.
Example of Warrant Coverage
Consider an investor purchasing 1,000,000 shares of stock at $5 per share, amounting to a $5,000,000 investment. The company grants 20% warrant coverage, issuing the investor $1,000,000 in warrants. Technically, the company guarantees 200,000 additional shares at an exercise price of $5 per share.
Issuing warrants does not provide the investor additional downside protection since the shares would be issued at the same price as initially paid. However, it ensures additional upside if the company goes public or gets sold at a price exceeding $5 per share.
What Is Warrant Coverage on a Convertible Note?
On a convertible note, warrant coverage allows the holder to purchase additional shares of a company. The amount allowed for purchase is a percentage based on the loan principal.
What Is a 10% Warrant?
Warrant coverage is based on the loan’s principal amount rather than the company’s value. For example, a 10% warrant coverage on a $1,000,000 loan equals $100,000 in warrants.
Why Do Companies Issue Warrants?
Companies issue warrants to raise capital. When a company sells a warrant, it receives immediate payment. If stocks are purchased using the warrant at a later date, the company receives additional funds.
Related Terms: warrant, option, capital, stock, shareholder, equity.
