When obtaining funds for a business venture, investors are often given warrants, a common kind of equity. A warrant gives its holder the right to buy a securities at a fixed or predictable price, known as the “exercise” or “strike” price, just like an option does.
Warrants and options are often confused. Options in the venture capital sector are typically long-term (up to ten years). They are typically given to employees, as opposed to investors. In contrast to employee options, warrants are tradeable as distinct instruments and work similarly to short-term options.
In general, the issuance and exercise of warrants (at least by non-employees) are not considered taxable events. In 1984, Congress actually reversed the IRS’s earlier position that the expiration of a warrant was a taxable event for the issuer. However, whenever a debt security with warrants attached is issued as part of a package, original issue discount problems occur.
One type of warrant that was once frequently utilized as a source of capital for new companies is contingent warrants. These warrants become exercisable if and when the holder does an act for the issuer, like buying a certain amount of products. Contingent warrants are no longer often used since the SEC ruled in favor of the issuer’s current and periodic recognition of expenditure.
A warrant is a “common-stock equivalent,” similar to an option, for accounting reasons. Furthermore, if a warrant has been “in the money”—that is, if the exercise price is less than the market price—for three consecutive months, it is deemed to have an impact on earnings per share under the so-called treasury-stock technique. Stated differently, the warrants are considered exercised, new stock is issued at the exercise price, and the issuer uses the funds to buy stock at the market price.
Warrants are a common type of equity instrument that companies seeking venture capital should consider and learn more about.