Warrants

Joseph W. Bartlett, Special Counsel, McCarter & English LLP, Co-Founder of VCExperts

McCarter & English LLP

2002-08-02

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A warrant is like an option and a conversion privilege, a derivative security, a right to buy a security at a fixed (or formula) price: the "exercise" or "strike" price. A warrant is, in effect, a short-term option. Although it is often issued in connection with another security—debt with warrants attached—it ordinarily can be, by its terms, traded as an independent security. In contrast, an option, in venture-capital usage at least, is usually long term (up to 10 years) and personal to the holder because the typical recipient is an employee. A conversion right is a right to purchase stock that is inherent in another security that is, a preferred stock or a debenture. Its characteristics are fixed in part by the security on which it is a parasite. All three labels refer to something that is, itself, a security.

Generally, neither the issuance of warrants nor their exercise (at least by non-employees) is a taxable event. Congress reversed the IRS's earlier position that the expiration of a warrant occasioned a tax on the issuer in 1984. However, whenever a debt security with warrants attached is issued as a package, original issue discount problems are invited.

If the issue engages a placement agent, the success fee to the agent is typically enhanced with warrant, expressed as warrant coverage. The exercise price is the same number as the investors pay for their security; "5% coverage" means that the agent gets enough warrants to convert into 5% of that number of shares which equals the number the investors bought.