Capital Raising
What Are Warrants? How They Work in Canadian Business Financings
Warrants can provide investors with additional upside and companies with potential future capital—but they also introduce dilution, valuation questions and contractual obligations.
Warrants frequently appear in private placements, public-company financings, convertible debt transactions and other capital-raising structures. They can provide investors with additional upside while giving the issuing company the possibility of receiving more capital in the future.
However, warrants also introduce potential dilution, valuation questions and contractual obligations that both companies and investors need to understand.
What Is a Warrant?
A warrant is a security that gives its holder the right—but not the obligation—to purchase a specified security, usually common shares of the issuing company, at a predetermined price before a stated expiry date.
The company issuing the underlying shares typically issues the warrant itself. If the holder later exercises the warrant, the holder pays the exercise price and the company issues the applicable shares.
A warrant normally specifies the number and type of shares that may be purchased, the exercise price, expiry date, number of warrants required for one share, when it becomes exercisable, transferability and any acceleration, adjustment or anti-dilution provisions.
A warrant may be issued alone or as part of a financing unit consisting of a share, debt instrument or other security together with a fraction or whole warrant.
A warrant is potential future capital—not guaranteed financing. Its value and likelihood of exercise depend on the company, its share value and the specific terms.
A Simplified Example
Assume a company completes a financing at $1.00 per share. Each share comes with one-half of a warrant, and each whole warrant permits the investor to purchase another share for $1.40 during the following two years.
An investor purchasing 100,000 units receives 100,000 shares and 50,000 warrants. If the shares later trade at $2.00, the investor may exercise and purchase 50,000 additional shares at $1.40. The investor pays the company another $70,000 and the company issues 50,000 new shares.
If the share price remains below $1.40 as expiry approaches, exercise may not make economic sense and the warrants could expire without value. Transaction costs, liquidity, taxes, securities laws and the precise terms can materially affect the result.
Why Do Companies Issue Warrants?
To make a financing more attractive
A warrant offers potential participation in future growth. That may help attract capital when investors perceive greater risk or market conditions make a conventional equity financing difficult.
To bridge a valuation gap
The company raises capital at an agreed current valuation, while investors receive an opportunity to increase ownership if the business performs. If exercised, the issuer receives the higher exercise price for the additional shares.
To support debt or convertible financing
Warrants may accompany a loan, convertible debenture or bridge financing, compensating the investor or lender for additional risk without requiring all compensation to be paid in cash.
To create the possibility of future capital
Cash exercises provide additional capital, but those proceeds are uncertain. Even in-the-money warrants may not be exercised immediately, and companies should not build financial plans that depend on them.
What Should the Issuing Company Consider?
Potential dilution
Exercise increases outstanding shares and can dilute existing shareholders’ ownership, voting influence and economic participation. Management should examine both issued-and-outstanding and fully diluted capitalization.
Exercise price and term
A lower exercise price generally gives the holder more potential value but may cause greater dilution at a lower valuation. A longer term gives the investor more time but can create an extended dilution overhang and complicate future financings or transactions.
Acceleration provisions
Some warrants allow the issuer to accelerate expiry if the shares trade above a specified price for a defined period. This may encourage exercise and reduce overhang, but the provision must be drafted and administered carefully.
Adjustments and anti-dilution provisions
Warrant agreements often adjust the exercise price or underlying shares after stock splits, consolidations, dividends, amalgamations or reorganizations. These provisions protect defined economic rights; they do not necessarily protect against every decline in value or future financing.
Accounting, tax and legal treatment
Warrants can affect financial reporting, taxation, securities compliance and transaction documents. Companies should involve qualified legal, accounting and tax advisers before finalizing a structure.
What Should an Investor Examine?
The number of warrants is only one part of the analysis. Investors should examine:
- The security that can be purchased and the warrant-to-share ratio
- The exercise price, exercisability date and expiry
- Any acceleration provision
- Transferability and resale restrictions
- Liquidity of the underlying shares
- Adjustments after a reorganization or corporate event
- Total dilution from all outstanding securities
- The company’s capital needs and business plan
A warrant should not be evaluated independently from its issuer. If the underlying business does not perform, the warrant may expire without value.
Warrants Are Not the Same as Stock Options
Both can provide a right to purchase shares at a predetermined price, but they are not interchangeable. Warrants are commonly issued to investors, lenders or transaction counterparties in a financing or commercial transaction. Stock options are frequently granted to employees, executives, directors or consultants as incentive compensation.
Documentation, transferability, securities regulation, accounting and taxation can also differ. A future CFM Insight will examine stock options and compare the instruments directly.
How Warrants Affect Transaction Economics
For an issuer, warrant coverage is part of the true cost of capital. A financing should not be assessed only by the cash raised and share price at closing.
For the investor, a warrant offers potential upside but does not remove the risk of the initial investment. A proper analysis considers pre- and post-financing capitalization, fully diluted ownership, probability and timing of exercise, potential future proceeds, value transferred through the warrants, future financing flexibility and the consequences of a sale, merger or liquidity event.
These considerations are especially important in private-company financings, where there may be no liquid market for either the warrants or underlying shares.
The bottom line
Warrants can help attract investment, bridge a valuation gap or compensate a lender for risk. They may also create dilution and structural complexity. For investors, value depends on the company, the warrant terms and the ability to exercise before expiry. The right structure is transaction-specific.
Sebastien Charles is the Founder and Managing Director of CFM Financial Consulting Inc. His experience spans entrepreneurship, corporate finance, M&A, capital raising, commercial financing, executive leadership and governance.
This article is provided for general informational purposes only. It is not investment, legal, tax or accounting advice, an offer to sell securities or a solicitation to purchase securities. Securities transactions involve risk and should be evaluated with appropriately qualified professional advisers.