What Is Warrant Coverage?
Let me explain warrant coverage directly: it's an agreement between a company and one or more shareholders where the company issues a warrant equal to some percentage of the dollar amount of an investment. You should know that warrants, much like options, let investors acquire shares at a designated price.
These warrant coverage agreements are there to make the deal more appealing for you as an investor, because they leverage your investment and boost your returns if the company's value grows as expected.
Understanding Warrant Coverage
As an investor, warrant coverage gives you assurance that you can increase your ownership in the company if things improve quickly. This happens through issuing warrants as part of your participation.
A warrant is a derivative that grants you the right to buy the underlying stock at a specified price before or at maturity, without any obligation to do so. Warrant coverage is essentially the agreement to issue stocks to cover potential future execution of that warrant.
Warrants resemble options but differ in key ways: they come from the company itself, not traders; they're dilutive because exercising them means the company issues new stock; and they can attach to other securities, like bonds, giving you the right to buy shares.
Reasons for Warrant Coverage
Warrant coverage lets you, the holder, share in the company's success through stock price appreciation. It also protects you against dilution from future share offerings, though ironically, exercising the warrant dilutes existing shares itself.
Companies issue warrants to draw in more capital. For instance, if they can't issue bonds at good rates, attaching warrants makes them more attractive. Warrants are often viewed as speculative.
A prime example occurred during the 2008 financial crisis with Goldman Sachs. They sold $5 billion in preferred stock to Warren Buffett's Berkshire Hathaway, including warrants for $5 billion in common stock at $115 per share, with a five-year term. At the time, shares traded around $129, offering Berkshire an immediate potential profit.
Example of Warrant Coverage
Consider this scenario: you invest $5,000,000 by buying 1,000,000 shares at $5 each. The company provides 20% warrant coverage, issuing $1,000,000 in warrants, which means guaranteeing 200,000 additional shares at $5 per share.
This doesn't add downside protection since the exercise price matches your purchase price, but it gives you extra upside if the company goes public or sells above $5 per share.
Warrant Coverage on a Convertible Note
On a convertible note, warrant coverage lets you purchase additional shares based on a percentage of the loan principal.
What Is a 10% Warrant?
A 10% warrant coverage is based on the loan principal, not company value. For a $1,000,000 loan, that's $100,000 in warrants.
Why Do Companies Issue Warrants?
Companies issue warrants to raise capital. They get payment when selling the warrant, and more money if you exercise it later to buy stocks.
Key Takeaways
- Warrant coverage offers shareholders a chance to gain extra shares as a perk of investing.
- It involves an agreement to issue warrants.
- Warrants act like options but are company-issued and dilutive to equity.
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