This guide will examine stock warrants and stock rights, how they work, their various types, how they are similar as well as different, and the pros and cons of each.
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What are stock warrants?
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How do stock warrants work?
If the issuing company’s stock price rises above the warrant’s stated price, the investor can redeem the warrant and purchase the shares at the lower price. The warrant expires if the stock never grows above the strike price, rendering it worthless. Most frequently, warrants are issued in conjunction with bonds to entice investors to buy into the security.
Stock warrant example
Unlike options, warrants cause dilution, meaning a company is obligated to issue new stock when a warrant is exercised. Therefore, when investors exercise their warrant, they receive newly issued stock directly from the company rather than already-outstanding stock. Additionally, warrants tend to have more extended periods than options between issue and expiration, often years instead of months.
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What are stock rights?
A company typically issues a rights offering when it wants to raise extra capital. But, like warrants, this type of offer causes dilution, lowering the value of shares as it creates more of them. Still, it also allows investors to hold their current stake in the company if they buy more shares.
They are often offered at a discount relative to the current market price. In addition, rights are often transferable, allowing the holder to sell them in the open market.
Recommended video: The cost of share dilution
How do stock rights work?
A rights issue is effectively an invitation by the company to existing investors to purchase additional new shares by the defined expiration date. Essentially, the company is giving shareholders an opportunity to increase their exposure to the stock at a discount price.
More specifically, this type of issue offers existing shareholders securities called “rights,” which they can trade on the market the same way they would with ordinary shares. As a result, the rights issued to current shareholders have value since they offer compensation for the future value dilution of their existing shares.
Dilution occurs because a rights offering spreads a company’s net profit over more shares. Thus, the company’s earnings per share (EPS) decrease as the allocated earnings result in share dilution.
The number of shares an investor has the right to purchase is proportional to their current slice in the company. So, if they choose to exercise their right, they’ll end up with the same percentage of ownership that they had before the additional shares were issued. On the other hand, if they decide not to purchase the shares, they’ll be left with a smaller stake in the company.
Subscription Right
A subscription right (“subscription privilege,” “preemptive right,” or “anti-dilution right”) is the right of existing shareholders in a company to retain equal percentage ownership by subscribing to new stock issuances at or below market prices.
The subscription right is typically enforced by using rights offerings, which allow shareholders to exchange rights for shares of common stock at a cost below where the stock is currently trading.
Types of Stock Warrants
There are call and put warrants. A call warrant represents a set number of shares that can be purchased from the issuer at a determined price on or before the expiration date. A put warrant represents a certain amount of equity that can be sold back at a fixed price on or before the expiration date.
The type of warrant will determine the degree of risk and value:
#1 Traditional Warrants
Traditional warrants are sold in conjunction with a bond (called warrant-linked bonds), which allows for a lower coupon rate on the bond. In addition, these warrants can often be detached from the bond and sold on the secondary market before expiration.
#2 Wedded Warrants
Wedded warrants remain attached to the bond, meaning if the holder wants to exercise the warrant and acquire their shares, the bond (the warrant is “wedded” to) must also be surrendered.
#3 Covered Warrants
Financial institutions rather than companies issue covered warrants (sometimes called naked warrants). New stock is not issued when covered warrants are exercised. Instead, the warrants are backed (covered) by the issuing institution that owns the underlying securities or can acquire them.
The underlying assets are not restricted to equity, like other types of warrants, but can be currencies, commodities, or other financial instruments, making them a lot more flexible.
Types of stock rights
There are two main types of rights offerings: direct rights offering and insured/standby rights offering.
#1 Direct rights offering
In a direct rights offering, a company issues rights to its shareholders and sells only the shares they decide to buy. If some rights go unexercised, the company doesn’t sell those shares.
This type of offering could result in undercapitalization (raising less capital than anticipated). As such, it is best suited for companies that want to raise money but don’t have a specific amount they need.
#2 Insured/standby rights offering
Insured/standby rights offerings, usually the more expensive type, allow third-party purchasers (such as an investment bank) to purchase unexercised rights. Here, each shareholder has the same right to buy additional shares, but the third party will buy them if they choose not to exercise their right. This type of agreement ensures the issuing company has its capital requirements met.
Stock rights vs warrants vs options
Warrants, stock rights, and call options are all types of options that can be exercised, traded, and can expire. Let’s look at some of the primary attributes that they have in common:
- Strike price or exercise price: the fixed price at which the holder has the right to purchase the underlying asset;
- Maturity or expiration date: the predefined time period during which the warrant, stock right, or call can be exercised;
- Option price or premium: the price at which the warrant, stock right, or option trades in the market.
- Option: all holders have the right without the obligation to exercise their option, warrant, or right.
Some significant differences between these derivatives include:
- Issuer: warrants and stock rights are issued by a specific company, though a secondary market that allows other buyers to acquire these securities often emerges. In comparison, an exchange or brokerage issues exchange-traded options. As a result, warrants and rights have few standardized features, while exchange-traded options can be more standardized (expiration periods and the number of shares per option contract);
- Capital: when a stock right or warrant is exercised, the company directly issues the shares of stock to the right or warrant holder. In this way, rights and warrants are a source of capital for companies. By contrast, the call premium is the fee paid by the buyer to the seller to obtain this right.
- Maturity: warrants usually have more extended maturity periods than options and rights. While they generally expire in one to two years, they can sometimes have maturities well over five years. Conversely, call options have maturities ranging from a few weeks or months to about a year or two (most expire within a month). Longer-dated options are likely to be relatively illiquid. Rights, too, are short-term instruments that expire quickly, generally between 30-60 days;
- Dilution: warrants and rights generate dilution because a company is bound to issue new stock when either of them is exercised. Exercising a call option, however, does not involve issuing new stock since a call option is a derivative instrument on the company’s existing share.
How to value stock rights and warrants
Like market options, rights or warrants become worthless if the stock’s market price falls below the exercise or subscription price. In addition, rights and warrants are also rendered worthless upon expiration regardless of where the underlying asset is trading.
Indeed, the values for stock rights and warrants are determined similarly to market options. They all have intrinsic value, equal to the difference between the market and strike prices of the stock, and time value, based on the stock’s potential to expand in price before the expiration date.
Calculating the value of stock warrants
Warrants have no intrinsic value at issuance since they are delivered with an exercise price above the current market price. Instead, they are assigned a waiting period, giving the stock price time to increase enough to surpass the strike price and provide intrinsic value.
To find the value of a stock warrant, you must first look up the stock’s current market price. You then subtract the exercise (subscription) price from the market price to arrive at the intrinsic value of the warrant. Finally, divide the intrinsic value by the number of shares that can be purchased with one warrant.
The formula for estimating the value of a warrant:
(Current price – Subscription price) / Warrants needed
Example
Calculating the theoretical value of stock rights
Unlike warrants, stock rights have intrinsic value at issuance as they give existing shareholders so-called “rights,” which provide them with the right to purchase new shares at a discount to the market value.
Similarly to warrants, to estimate the value during the exercise of rights period, you must first find out the stock’s current market price. Followed by subtracting the subscription price from the market price and dividing that by the number of rights needed to buy one new share.
The formula for the value during the exercise of rights period is as follows:
(Current price – Subscription price) / Rights needed
Example
The theoretical value during the exercise of rights period differs from the value during the cum rights period.
The formula for the value during cum rights period:
(Stock price – Subscription price) / Rights needed plus 1.
*Cum rights: Shares that still have rights available to them, up until three days before the subscription rights expire.
*Exercise of rights period: when rights trade independently of the stock, period of time about three days before expiration.
How are stock rights and warrants taxed?
Rights and warrants are taxed like any other security. Stock rights are not taxable if they are exercised. Therefore, any gain or loss is realized when the acquired stock is sold. The difference between their exercise and sale price is taxed as a long- or short-term gain. Any gain or loss obtained from trading rights or warrants in the secondary market is taxed similarly (except that all profits and losses will be short-term).
Pros and cons of stock warrants
Pros
- Leverage: Warrants can provide greater exposure to an underlying stock’s price movement without requiring the full capital outlay needed to own the stock outright. This can amplify gains if the stock moves favorably;
- Flexibility: Warrants give investors the option, but not the obligation, to buy the underlying stock. If the stock does not perform as anticipated, the investor can simply let the warrant expire;
- Longer time horizon: Compared to stock options, warrants often have a longer time to expire, sometimes several years. This extended timeframe can give investors more opportunity for the underlying stock to appreciate;
- Potential for higher returns: Due to their leveraged nature, warrants can provide higher returns relative to the initial investment, especially if the underlying stock performs well.
Cons
- Leveraged losses: The same leverage that can amplify gains can also amplify losses. If the underlying stock doesn’t perform well, the percentage loss on a warrant can be significant;
- Expiration: Unlike stocks, which can be held indefinitely, warrants have an expiration date. If not exercised by this date, they become worthless;
- Dilution: If many warrant holders exercise their warrants at once, it can lead to stock dilution, potentially affecting the stock’s price negatively;
- Limited dividends and voting Rights: Holders of stock warrants are not entitled to dividends or voting rights until they exercise their warrants and own the underlying stock.
Pros and cons of stock rights
Pros
- Discounted price: Stock rights typically offer shares at a discounted price compared to the current market rate, providing an immediate value proposition to the rights holder;
- Proportional ownership: Rights allow existing shareholders to maintain their proportional ownership in a company. This is especially important if they want to avoid dilution when new shares are issued;
- Flexibility: Investors have the choice to exercise their rights and buy the shares, sell their rights on the open market (if they’re tradable), or simply let them expire;
- Potential for profit: If the rights are offered at a significant discount and the investor believes in the long-term prospects of the company, there’s a potential for profit when acquiring additional shares at a reduced rate;
- No obligation: If the investor feels the company’s prospects are not favorable, they can simply let the rights expire or sell them.
Cons
- Additional investment required: To take advantage of the rights, investors need to commit additional capital to purchase the new shares;
- Opportunity cost: The money used to exercise rights might be better used elsewhere, especially if other investment opportunities provide a higher expected return;
- Potential dilution: If an investor chooses not to exercise their rights (and doesn’t sell them either), their percentage ownership in the company will be diluted when others exercise their rights;
- Short exercise period: Rights offerings usually come with a limited window for decision-making. Investors might feel rushed to decide whether to invest more capital;
- Market perception: Sometimes, a rights issue can be perceived as a sign that a company is desperate for capital, which might negatively affect the stock’s price;
- Decreased dividends: If the company doesn’t deploy the raised capital efficiently, the issuance of additional shares can lead to decreased earnings per share and potentially lower dividends.
In conclusion
Both stock warrants and rights provide investors the option to buy shares at a predetermined price. While they share this core function, their purposes and implications vary. Rights are designed to shield existing shareholders from dilution, giving them priority to purchase new shares, often at a discount. In contrast, warrants are generally offered as incentives to potential investors or bondholders, and they don’t directly prevent dilution. Both tools can influence a company’s capital structure and offer potential upside for investors, but understanding their specific terms and implications is crucial for informed decision-making.
Disclaimer: The content on this site should not be considered investment advice. Investing is speculative. When investing, your capital is at risk.
FAQs about stock rights and warrants
What are stock rights?
Stock rights allow existing shareholders to buy a pro-rata allocation of additional shares at a specific price and within a predetermined period. A company typically issues a rights offering when it wants to raise extra capital. To protect its current shareholders from value dilution, it offers them securities called “rights” at a discount price which they can trade on the market the same way they would with ordinary shares.
What are the types of stock rights?
There are two main types of rights offerings. In a direct rights offering, a company issues rights to its shareholders and sells only the shares they decide to buy. An insured/standby rights offering allows third-party buyers to purchase unexercised rights. Each shareholder has the same right to buy additional shares, but the third party will buy them if they do not exercise that right.
What is a stock warrant and how does it work?
A stock warrant allows the holder to purchase an underlying security at a specific price and quantity for a particular future time. Warrants are issued directly by the company and typically with an exercise price above the current market price and have a waiting period assigned to them, giving the stock price time to increase enough to exceed the strike price and provide intrinsic value. Like stock rights, warrants cause dilution, so it’s advised for shareholders to exercise their rights.
What are the types of stock warrants?
There are call and put warrants and three types that will determine the warrant’s degree of risk and value. Traditional warrants are sold in conjunction with a bond but can often be detached from the bond and sold on the secondary market. Wedded warrants remain attached to the bond. Lastly, covered warrants are issued by financial institutions rather than companies and can be backed by various underlying assets.
What is the difference between warrant vs stock?
A stock warrant is a financial instrument issued by a company that gives the holder the right to purchase the company’s stock at a specified price before a set expiration date. In contrast, a stock represents actual ownership in a company, including a share in its assets and earnings. Owning a stock means you are a shareholder of the company, whereas holding a warrant gives you the right to buy the stock in the future under specific conditions, but does not convey any immediate ownership or shareholder rights.
What will happen when stock warrants expire?
When stock warrants expire, they become worthless. If the warrant holder does not exercise the warrant before its expiration date, it no longer has any value, and the opportunity to buy the underlying shares at the exercise price is lost.
If I have a warrant, how do I convert warrants to shares?
To convert warrants to shares, you’ll need to exercise the warrant. This involves paying the specified exercise (or “strike”) price. Once you’ve done that, the company will issue the corresponding number of shares to you.
What is the difference between warrants vs options?
The primary distinction between warrants vs options is the issuer. Companies issue stock warrants, whereas options are derivative contracts traded on exchanges. Furthermore, stock warrants often have longer expiration periods than options, sometimes several years.
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