Warrants and Convertibles

This article begins with a brief history and an overview of financial investment vehicles, providing insight from the corporate as well as the investor's perspective. The reader is offered a detailed description of warrant certificates and convertible bonds, underscored with the benefits and disadvantages of each. The circumstances under which warrants or convertibles are issued by companies as a financial vehicle for investors, as opposed to common or other types of stocks or bonds is made apparent, offering valuable perspective to potential investors or issuers of these vehicles. The role of the Securities and Exchange Commission (SEC) in governance and oversight of companies' security offerings is not insubstantial and a brief high-level mention is delivered in this review.

Keywords Bear Market; Bonds; Calls; Commodities; Convertibles; EITF-00-19; Financial Accounting Standards Board; Investment Vehicles; Options; Preferred Stock; Puts; Securities and Exchange Commission; Stock Option; Volatility; Warrants

Finance > Warrants & Convertibles

Overview

Historical Perspective on Investing

In 1792, the first organized stock exchange was transacted in New York. Financial leaders at the time developed and agreed to a formal document of rules, regulations and fees for trading stocks and bonds; hence the launch of the stock market phenomenon. In simpler times, securities were auctioned off to the highest bidder, with the seller paying a commission on each stock sold. History holds lessons for the experienced, in terms of investments and risk, highlighted in the rapid growth in the stock market and in investors' frenetic drive to swift profits.

In addition to investors' entrepreneurial drive, interest in the common good has played a vital role in the world of stocks, bonds and investments. Soon after the United States became involved in World War II, it became paramount to enhance the efficiency and safety of existing rail transport systems. Success in the wartime endeavor hinged upon accessibility and mobility for people and resources. The railroad system at the time was woefully inadequate in terms of financing, which subsequently disadvantaged the rail's ability to meet demand.

The Interstate Commerce Act of 1887 was responsible for having created the Interstate Commerce Commission, which, under great influence from private farmers and others, prohibited the railroads from increasing rates sufficient to meet growing operating costs. Compounding the cash scarcity, the strict regulations most certainly prevented the rail from creating a positive financial margin with which to make needed capital investments in the company. Put simply, the railroads, a key element in our nation's transportation infrastructure, simply could not support growth or sustain operations without investors and their cash. The railroads ultimately were built with money from men who hoped to earn a large profit from their investment in operations and capital.

In context, today's large corporations with vast numbers of stockholders still rely on investors' interest to grow, much as the railroads offered a financial interest and a public service to the country during a critical time of conflict. The story of economics has always been influenced by enlarging corporations, in particular those representing importance to the public at large. Commodities, such as oil, wheat, corn and soybeans, are a modern day example of investments of great public import and guaranteed financial growth. The rail of yesterday, given its history, might well have been considered a primary commodity of its time.

Applications

Investment Vehicles

Companies can offer investors numerous venues in which to place their financial interests and test their financial expertise, no matter their level of experience. Corporations may finance part of their business by leveraging themselves with securities they promise to pay back, with interest, in addition to the principle. Variations on this model will be introduced later in this essay. The more debt the company incurs, naturally, the higher the organization's financial risk. A few examples of investment vehicles utilized by corporations and the government to support their financial needs include:

• Convertibles;
• Corporate, municipal, or treasury bonds;
• Common Stock;
• Commodities markets;
• Governmental, corporate and municipal bonds;
• Warrant certificates.

Warrants

Common stock warrants offer the investor the right to buy common stock at a specific price, in the future, within a set period of time. In some cases, warrants have no expiration date; these are known as perpetual warrants. If one were looking to identify warrants on the stock listing, he or she would look for the suffix "wt." An installment warrant is an option that offers a share on credit; with the installment vehicle, the investor pays for half the share now and for the rest later. The initial installment provides the owner half a stock. The premise behind installment warrants is that they represent a long term call option (opportunity to exercise a warrant when stock price exceeds the initial investment price, resulting in a net profit) for investors who are inclined to speculate that the price of stock will increase in the long term; the longer the life before the warrant's expiration, the higher its value and the safer the investor's money. The anticipation for the investor is that the company will see increased profits in its future years, thereby growing its dividends. The owner of the warrant can watch and speculate (within the context of the expiration date) until such time as the stock and dividends look attractive enough to 'exercise' or turn the warrant over to stock ownership.

It is evident that investors should educate themselves thoroughly in the warrant vehicle and the issuing company before making this somewhat speculative investment; this education includes attention to transaction costs which will impact profit and loss calculations. "ABN AMRO's {a global banking group) Aaron Stambulich notes that while installments offer a lower-risk form of leverage than other forms of equity lending, investors still need to spend the time acquiring the knowledge to use them properly,'" (Walker, 2007).

Shorter term warrants do exist; they represent a higher risk with a robust appeal of higher returns to the investor. Both long and short-term warrants are priced lower than the common stock purchase price, thereby creating leverage and risk to the corporation, similar to bond arrangements (bonds are in essence a loan with interest). Warrants, however, do not earn interest and usually have an expiration date which can vary depending on the model employed; the key point is that warrants become worthless at expiration date or when the cost of common stock drops to a very low rate. Warrants offer no dividends or voting rights to the warrant owner. "{Warrants} are derivatives — this means they derive their value from and give investors exposure to an underlying asset, such as a share, basket of shares, index, currency or commodity, at a fraction of the underlying asset's cost (Walker, 2007).

Valuation of the Warrant

The value of the warrant is the price of the company's common stock minus the warrant's option price. As a simple example, if the price of the warrant certificate is $15 and the common stock purchase price is $20, the warrant is worth $5. In contrast, if the warrant certificate price is $20 and the stock price is $15, the warrant holds no value. It will remain so unless the stock price, in this case, enjoys favorable appreciation to bring its value above the warrant price. The higher the common stock's price, obviously, the greater the warrant's value. If the common stock is volatile, all the better for the warrant owner, as this too increases the value of the warrant.

When a warrant certificate is exercised (turned over for stock ownership) the number of shares in the company increases and the stock price does decrease overall. If there are warrants outstanding, the owners of the stock are obligated to satisfy the call (exercising) from warrant holders. The money paid to purchase the warrant at the outset goes directly to the company as does the money paid when the owner exercises the warrant to purchase common stock. The new shares generated through an exercised warrant are accounted for in financial reports as fully diluted earnings per share, which represents what the earnings per share would be if all warrants were exercised and all outstanding convertible securities, were converted to stock. In essence, the denominator (total outstanding shares) increases, so the value of earnings per share dips lower.

Warrants are sometimes attached to bonds or preferred stock as a means to reduce the interest or the dividends that have to be paid to sell the securities. These particular warrants, issued in this bundled format can be separated and traded independently of the bond or stock and are termed detachable warrants.

Warrants as Stock Options

In today's highly competitive environment, companies struggle to attract a strong, talented workforce. Stock options, sometimes offered as an enticement to potential employees, are commonly issued by companies in the form of a warrant. Start-up companies will offer the stock option as an alternative or adjunct to salary, in order to minimize cash expenditures, while creating an attractive option for recruitment purposes. The disadvantage of warrant stock options, if exercised, is that it decreases the value of the existing shareholders' stock, as referenced earlier in this essay.

Public Accounting & the Securities and Exchange Commission (SEC)

When a warrant is exercised (converted to stock), although it means more funds for the company, the company's balance sheet has historically retained the debt.

"Issuers ordinarily expect to account for common stock and warrants as equity, and account for debt as liabilities" (Dyson, 2007). The Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC) recognize that for issuers there may be inconsistency and misinterpretation on how warrants and convertibles are reported on the books. The SEC has required registrants {of the SEC} to restate their financial statements to reflect its current interpretation of the existing literature (Dyson, 2007). Companies' first step is to identify whether they fall under the scope of the FASB's SFAS 150 which lists the various features of securities placing the instrument as a liability as opposed to an asset. The author of Freestanding Warrants and Embedded Conversion Options, Robert A. Dyson, cautions as follows:

It is not within the scope of this essay to provide financial accounting direction, rather to provide to the business reader highlights of important issues and an awareness of corporate obligations. Identifying regulatory applications and staying abreast of constantly changing directives and definitions is a key to the success of any executive whose business is involved with sales or investment in financial vehicles.

Convertible Securities

There are two types of convertible securities addressed in this essay: First is the convertible bond and the second is convertible preferred stock.

• First, the convertible bond is, by definition, issued by a corporation, and not by the government. A convertible bond is nothing more than an arrangement whereby the bond can be converted into specific predetermined numbers of common stock in the company, should the bondholder exercise the option. A conversion price is identified so as to make the security attractive when the stock price increases substantially. The value of the bond is not an exact science, but represents the estimate of the value of common stock in the company at the time of its issuance, as if there were no conversion options. The conversion ratio dictates how many shares into which the convertible bond can be converted.
• Preferred stock convertibles provide for conversion of the security to preferred stock, which is a favorable class of ownership in which the investors' dividends are paid out before common stock dividends are. Preferred stock owners generally do not have voting rights, unlike common stockholders. The preferred stock is attractive to some investors because it offers fixed dividends as well as appreciation in shares (e.g. equity) in the company.

Convertibles are more attractive to the issuing company than are other types of bonds, because the interest paid on the convertible is lower. A second attractive feature of the convertible bond to the issuing corporation is that it does not, like a warrant, issue new stocks to shareholders or dilute existing stock value. The formula used to transition preferred convertibles to common stock generally includes an anti-dilution provision, of particular import to owners. Similar to warrants, convertibles are attractive to investors who have reason or hope to believe that the company's ultimate stock value will go up. The investor, of course, should be well informed about the company into which he or she is investing money; the value of research, knowing the market and experience cannot be overstated. Companies issuing convertibles tend to be the more speculative ventures on the whole and should alert the investor to watch for risk as well as opportunity.

Advantages of Convertibles

Advantages of convertibles, to the investor, include their tendency not to dip as greatly in value in a Bear Market (a downturn and devaluation in the market) as do common stocks. Should the company go into default (inability to pay), convertibles can be transitioned safely to a bond or preferred stock. In purchasing convertible securities, the investor enjoys the safety of a bond yet is offered the opportunity for value appreciation. Another very attractive feature of convertibles is that they may be purchased through tax-deferred retirement accounts. This represents an opportunity which swings some investors readily to this option.

Disadvantages of Convertibles

Disadvantages of convertible securities include the expectation that they yield less than the common shares or a bond issued by the corporation. Investors should take heed that companies issuing convertibles are often those facing a financially challenging situation, and may be issuing convertible securities as a last chance option for garnering monies for financing. Another disadvantage of convertibles is that the issuing companies may also call the bond, forcing conversion to common stock at a convenient time for the issuer, which may not be a favorable time for the investor to convert. If the common stock price reaches a specified ratio, the issuer is permitted to force conversion before the end before the end of the normal protection period.

Case Study — Ford Motor Company

Ford Motor Company, facing substantial losses in its North American market, and facing near-term liquidity issues, announced plans in late 2006 to raise $18 million to restructure its operations, $3 million of which will be sold in the form of convertibles, which would be converted to Ford Common Stock. A company the size of Ford entering such a high yield market for the first time has raised some eyebrows. Shelley Lombard, senior high yield analyst for the New York company, Gimme Credit, states, "The fact that this issuer has not been in the high yield market before and that this company is a very troubled company is what makes this significant" (S., M., & S., G., 2006). Matt Eagan, a portfolio manager with the Boston-based company, Loomis and Sayles states, "Market demand is high and hedge funds will be hungry for Ford's bonds, particularly if they are convertible bonds. If they do end up issuing a convertible bond, we see that there's a lot of demand in that space" (S., M., & S., G., 2006). It is predicted that this unusual offering from Ford could be precedent-setting if successful in growing the companies' capital. Other large corporations will take notice and possibly follow suit.

Case Study — In the Throes of Financial Difficulty for Luminent

Luminent Mortgage Capital, Incorporated, has defaulted on a $90 million debt and is facing even more financial difficulties. Issuing of warrants as an investment vehicle, with the assistance of Arco Capital Corporation will occur in an effort to preserve the financial survival of the company. American Banker reports: "Arco Capital Corp. Ltd. of San Juan, Puerto Rico, has agreed to provide up to $125 million of financing to {Luminent Mortgage Capital Inc}, a San Francisco real estate investment trust (Hochstein, 2007). "In return", Luminent said Monday, "Arco has received warrants to buy a 49% voting stake and a 51% "economic interest" in the REIT at an exercise price of 18 cents a share. The warrants are good for five years beginning Aug. 30" (Hochstein, 2007).

Luminent acknowledged "the possibility of sizeable dilution to existing … stockholders" as a result of the issuance of warrants" (Hochstein, 2007). However, it also said the board's audit committee, "pursuant to an exception provided in the New York Stock Exchange's stockholder approval policy, expressly approved the decision not to seek stockholder approval for the issuance. The committee did so because delays in securing such approval "could, given the external climate, seriously further jeopardize the financial viability of Luminent" (Hochstein, 2007).

Case Study — Good News for Mirant Warrant Holders

"With the $45 billion buy out of TXU {a Dallas based energy company} looming in the smokestacks, chatter of a possible Mirant deal has intensified, bringing to light what is arguably the best play on the utility — its warrants. Should Mirant, an international electricity and producer and seller be acquired for $41 per share, as some analysts estimate, warrant holders will realize a 22% gain, while holders of common stocks will gain 10%. The warrants were purposely developed to protect their owners in case of a cash takeover," (Louria, 2007). For warrant holders, this is good news because specific features were built into the warrants which will very possibly create a windfall for them, contrary to usual happenings in cash takeovers. Until recently, protective features on warrants were not common; but in today's environment of rapid company buy-outs, investors are well-advised to be alert to the availability of such safeguards.

Case Study — Competition for a Warrant offered by Money Magazine

In a well-received competition just this year (2007), warrants were offered to the readers of Money who could most closely predict the price of commodities; oil in particular. The response was "A wave of Money readers {trying} to estimate the price of oil a couple of months ahead — a keen investor from Canberra is the winner," (Field, 2007). Commodities have become an attractive vehicle to investors because of the wide global demand for oil as well as growing international tensions with oil-rich countries; these tensions are likely to drive the cost of oil even further. Anyone driving a motorized automobile today is acutely aware of the impact of cost increases in oil. Warrants were offered as a desirable investment vehicle; the response clearly supported the growing attraction of this option. "Part of the appeal of commodity warrants lies in the leverage they offer. Warrants require a far smaller investment than the underlying futures contracts, and the percentage returns can be very high. Investors in commodity warrants certainly don't have to wait long to know if they have made or lost money. For the record commodity warrants issued by CWA (Commodity Warrants Australia) have an average term of 92 days though the average time to maximum profit is just 16 days. CWA says, between August 2005 and February 2007 — a period during which demand for commodities has boomed — around 65% of CWA's commodity warrants generated a positive result, with the average return being 38.4% (Field, 2007).

Conclusion

Knowledge is power, and loaning, buying or selling in the financial market should be approached with much thoughtful preparation. Smaller investors may unwittingly put their trust in an advisor, thinking their investment is safer with what he or she thinks may be an expert in the field. Investment costs and financial risks should be of paramount import to the investor, who is closely monitoring the market for attractive opportunities which provide sufficient safety to meet the investor's comfort level.

Companies, accountable to shareholders or stockholders, rely on their historical performance and their projections for success in the future. Wise resource management, accountability and attention to the SEC guidelines, current and future, are the responsibility of the company attracting the investor. This essay has given a broad overview only and has hopefully enlightened investors and issuers alike to the vast risks and opportunities available in the exciting work of financial markets.

Terms & Concepts:

Bear Market: A prolonged period in which investment prices fall, a time of accompanied by extensive doubt and distrust in the market.

Bonds: A debt security, essentially a loan for which the issuer owes the holders a debt, and is obliged to repay both principal and interest of the debt at maturity date.

Call: A contract that gives the holder the right to purchase a given stock at a specific price within a designated period of time.

Commodities: A term for products of value, for which there is demand. The resources are produced in large quantities by many different producers; the items from each are considered comparable — some examples include oil, soybeans, and pork bellies)

EITF-00-19: 'Emerging Issues Task Force '- formed in 1984 in response to the recommendations of the FASB's task force on timely financial reporting guidance; available for public viewing. (http://www.fasb.org/eitf/about%5feitf.shtml).

FASB (Financial Accounting Standards Board): The designated United States (private sector) organization that establishes financial accounting and reporting standards

Investment Vehicle: Broad term defining any method by which money can be invested

Preferred Stock: Preferred stock is typically a higher grade stock than common stock, allowing for dividends to be paid out to the investor before payout to common stock holders.

Puts: An option that allows the holder to sell a given stock at a specific price within a designated period of time.

Securities and Exchange Commission: A U.S. Federal Agency responsible for enforcing the federal securities laws and regulating the stock market and securities industry (stocks, bonds, etc).

Stocks Option: An employee stock option is a call option (see "call' above) on the common stock of a company, representing a non-cash compensation for the employee, an incentive to participate in the company's success.

Bibliography

Dyson, R. (2007). Freestanding warrants and embedded conversion options. CPA Journal, 77, 40-49. Retrieved September 15, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=24729316&site=ehost-live

Field, N. (2007). Warrants winners. Money (14446219), , 94-95. Retrieved September 17, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=25890115&site=ehost-live

Kim, W., Kim, W., & Kim, H. (2013). Death spiral issues in emerging market: A control related perspective. Pacific-Basin Finance Journal, 2214-36. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=85174023&site=ehost-live

Louria, A. (2007). Hoping for a warrant windfall. Investment Dealers' Digest, 73, 9-14. Retrieved September 16, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=24341643&site=ehost-live

S., M., & S., G. (2006). Ford may jump start with new convertible bond. High Yield Report, 17, 1-8. Retrieved September 16, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=23305561&site=ehost-live

Schwienbacher, A. (2013). The entrepreneur's investor choice: The impact on later-stage firm development. Journal of Business Venturing, 28, 528-545. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=87734829&site=ehost-live

Walker, C. (2007). Get a lot for a little. Money (14446219), , 86. Retrieved September 16, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=25890106&site=ehost-live

Wigan, D. (2013). Convertible bonds: Investors seek convertible cover from rate rises. Euromoney, 43, 38. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=92025076&site=ehost-live

Suggested Reading

Daves, P., & Ehrhardt, M. (2007). Convertible securities, employee stock options and the cost of equity. Financial Review, 42, 267-288. Retrieved September 16, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=25276408&site=ehost-live

Koh, P. (2007). Convertibles' Atlantic drift. Euromoney, 38, 44-44. Retrieved September 16, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN= 24291287&site=ehost-live