Warrants: What They Are and How to Use Them

If you're considering using warrants in your business, it's important to structure them carefully. Done wrong, warrants will dilute your ownership in the business and won't motivate anyone to build the company.

Like stock options, warrants are a tool businesses can use to reward key employees or investors. Warrants give an individual the opportunity to buy stock in your company at a preset price, for a set period of time. While stock option terms are often short, warrant contracts are often long, lasting up to 15 years. A longer term is often more attractive because it gives the warrant holder more time for the company’s stock to rise high enough to make the warrants exercisable.

The stock exercise price for the warrants is usually set higher than the current value of the company's stock, to motivate the employee or investor to help make the company successful. If the company grows, the value of company stock increases.

If the stock value goes at least as high as the exercise price, the warrants are "in the money" and the bearer may purchase stock. If the stock is valued higher than the agreed-upon purchase price, the warrants owner may purchase the stock and then immediately resell it at a profit.

Here's an example:

ABC Company takes on Angel Investor. The company's private stock is worth $5 a share at the time. Angel invests $500,000 in the business and also receives warrants to purchase 10,000 shares of company stock within the next three years at $10 per share.

Two years later, ABC's sales and profits are up, and its stock is now worth $12. Angel exercises the option granted by the warrants and purchases his shares at $10. He then resells them for $12, pocketing a $20,000 profit.

That's the scenario for a warrant holder if all goes well. If when the warrants' expiration date arrives the stock isn't worth at least as much as the agreed-upon exercise price, the warrants are worthless. (No one is going to buy the stock at a price higher than other investors would pay.) In this case, the warrants expire, and the owner does not end up purchasing any company stock.

To prevent this scenario from going wrong, consider the following points:

• Don't give warrants to everyone: People who receive warrants should be important to the success of the business. If you hand them out to everyone, you could substantially dilute your ownership stake.
• Don't give out warrants at the current stock price: Warrants just become a quick company-equity giveaway if they can be exercised immediately.
• Tie warrants to company performance: In addition to the stock simply hitting the target price, you can require that the company achieve clearly defined goals for the warrants to be exercisable, such as getting 1,000 new customers or cracking $10 million in sales.
• Use multiple expiration dates: Stringing out the warrant dates can keep employees and investors motivated through the years. For instance, managers might be able to exercise 10 percent of their warrants in a year if they meet certain targets, another 50 percent in three years, and the final 40 percent in five years.
• Set realistic stock prices: If you set a sky-high target price that doesn’t seem achievable in the warrants' time frame, owners may soon become disillusioned, and angry. Get realistic projections for your company's hoped-for growth and a professional valuation of how that would increase the stock value, so you can set exercise prices that seem achievable to the warrant holders.

Business reporter Carol Tice contributes to several national and regional business publications.