Nov 29, 2022
A Brief Guide to Stock Appreciation Rights (SARs)
In this blog we will try to cover what SARs are and what are its pros and cons over ESOPs.
Warrants are a financial instrument at the hands of the companies, and they can be issued to investors with a right to either buy or sell the warrants at a specific price before the expiration date. They are a type of derivates, that are like a contractual agreement between two parties, and they determine their value based on the performance of an asset, in this case, it is the stocks of the company.
Warrants are similar to Options, as both give the holder the right but not the duty to sell the underlying shares at a predetermined price in a specific timeframe. In this blog, get accustomed to what warrants are, how they are issued, and how they are different from options.
Warrants are mainly classified into two types.
If a warrant never becomes profitable, the holder may leave the warrant to expire. For example, suppose an investor got the right to sell the shares of the company at a cost of $100/ share for 18 months from the date of issuance, but the price of the share never exceeds $60. In such a scenario, an investor might let the warrant expire.
Further, a warrant can be detachable or non-detachable in nature. In a detachable warrant, the warrant holder can choose to sell the warrant but keep the underlying security, like a bond or a stock. In a non-detachable warrant, there is a mandatory clause to sell the underlying stock or bond along with the warrants.
For founders, a warrant is an attractive financial instrument to lure strategic investors to their company. It helps them raise capital without any upfront equity dilution. On the other hand, investors can lock the share price for themselves without paying the whole amount upfront.
But there are some disadvantages to warrants as well. For example, warrants are volatile in nature and give no voting rights until converted to common shares. The underlying securities of a warrant are directly subject to market risks. If the value of its shares drops, it leads to losses for the investors. Further, they lapse if not redeemed before the expiry date.
Pro Tip: While issuing warrants, don't forget to add them to your cap table. By adding warrants to the cap table, you can track the warrant progress and avoid unexpected dilution for other equity holders.
Imagine Rohit is an investor who intends to purchase warrants of a company. The company offers him 1,000 warrants in the ratio of 1:1. That means Rohit needs to purchase one warrant to buy one share of the company in the future. The expiry date stands at 18 months from the date of the warrant’s issue.
The company sets the warrant price as ₹ 100/warrant and an exercise price of ₹ 400/warrant. Initially, Rohit pays ₹ 100,000 to purchase 1000 warrants. These warrants give him the right to buy 1,000 shares of the company within 18 months from the warrant purchase date.
Suppose Rohit exercises his right to buy the shares after one year when the value of each share is ₹ 600. Hence, Rohit purchases all the 1,000 shares at the agreed exercise price of ₹ 400/share by paying an additional ₹ 300,000.
And he sells all the shares on the same day at ₹ 600/share. So, he gets ₹ 600,000.
Profit = Money gained by selling shares - Total Warrant Price - Total Exercise Amount
Profit = ₹ 600,000 - 100,000 - 300,000 = ₹ 200,000.
Hence, by purchasing the warrant and selling the company’s shares, Rohit gains a profit of ₹ 200,000.
Warrants are regulated by Companies Act, 2013; SEBI (ICDR) Regulations, 2009; and FEMA Regulations.
There is no direct mention of warrants under the Companies Act, 2013. It is treated as security. According to Section 68(8) of the Act, if a company has repurchased the equity shares and six months has not passed, the company can reallot the shares as per sec 68(8).
Regulation 4(3) of SEBI (ICDR) Regulations, 2009 deals with the issue of warrants in India. These regulations were recently amended in 2015.
According to Section 2(za) of FEMA Act, warrants are treated as securities.
Warrants and options are largely similar, as they both give the holder the right to buy or sell an underlying stock at a specific price for a specific period. The primary difference between the two is the parties involved. A warrant is issued by the company to the investor, whereas options are exchanged between investors, that is, one investor sells them to others.
The expiration period of options and warrants also differs significantly from one another. A company may provide equity warrants with up to a 15-year expiration period. On the other hand, options can expire after three, six, nine, one, or three years.
Another distinction between warrants and options is how they affect the number of equity shares that are readily available. The underlying stock has already been issued by the corporation by the time an investor sells an option. An organization usually offers fresh shares to an investor who purchases a warrant and executes it. As a result, issuing warrants may reduce other shareholders' ownership interests.
Warrants are an effective instrument in the hands of companies to issue them as a preferential allotment to promoters or investors. It gives them the right to buy company shares at a predetermined price within a stipulated time frame, usually through the payment of an upfront amount to the warrant issuer. This allows these parties to increase their stake and gain profits when the performance of the company (hence the stock price) is growing remarkably.
Companies often issue warrants to entice investors into buying their offerings. Investors have to keep track of the market movement as it is very volatile. Warrants are a risky but definitely high-return investment tool.
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