In yesterday’s essay Learn This Secret and You Might Never Buy “Regular” Stocks Again, I described why elite investors cherish private placements. Private placements can make you 10, 20, even 50 times your money on a single investment.
Despite their power, private placements are one of the most misunderstood financial vehicles on the planet. In today’s essay, I’ll explain more about “warrants,” which are a critical component of private placement investing.
Because of the creation of “Project Ironman,” having this information is incredibly valuable right now.
The Basics of Warrants
When a company raises money in a private placement, it issues a “unit,” which consists of a share and a warrant.
You know the basics of “shares.” They are ownership stakes in businesses. This section will cover the second part of private placement financings: warrants.
Like many financial vehicles, warrants have some “moving parts” you need to understand in order to properly use them.
Remember, a warrant gives the holder the right but not the obligation to buy a stock at a predetermined price at a predetermined point in the future. There are many different types of warrants.
For example, a warrant might grant its owner the right but not the obligation to buy a stock at $2 per share at any time over the next two years. Or, a warrant might grant its owner the right but not the obligation to buy a stock at $1 per share over the next five years.
Strike Price: Lower is Better
The first aspect of a warrant you need to know about is the “strike price.” This is the price at which you can buy stock at some point in the future.
If a warrant has a strike price of $2, that means you will be able to buy company stock at $2 at some point in the future.
In the case of warrant with a strike price of $2, if a resource company is trading for $1 per share, the warrant has no intrinsic value. But if the company achieves major success and sees it stock price soar to $6, the warrant will have an intrinsic value of $4, since it allows you to buy stock for $2 per share, which you could then sell for $6 per share (6 -2 = 4).
When the share price of a stock is trading above the warrant’s strike price, we say the warrant is “in the money.” When the share price of a stock is trading below the warrant’s strike price, we say it is “out of the money.”
The closer the strike price is to the current stock price, the more likely the warrant is to go or expire in the money, and the more it will be worth. In most private placements, the strike price of the warrants is higher than the private placement share price.
Expiration Date: Longer is Better
The second aspect of a warrant you need to know about is the “expiration date.” This is the date at which the contract expires.
After the contract expires, neither the company nor the holder have any rights or obligations that were associated with the warrants. If a warrant expires “out of the money,” it is worthless.
The longer out the expiration date is in the future, the more time a company has to achieve success and a higher share price, and the more the warrant will be worth.
In other words, all things being equal, a “3-year” warrant is worth more than a “1-year” warrant… and a “5-year” warrant is worth more than a “3-year” warrant.
Most warrants issued in private placements have expiration dates 1 – 5 years in the future.
It’s rare that more valuable “5-year” warrants are issued by companies.
Conversion Ratio: More is Better
The conversion ratio of a warrant is the number of shares applicable to the warrant.
Some warrants are good for one-quarter of a share, which is known as a quarter warrant. This means you need four warrants to buy one share.
Some warrants are good for one-half of a share (you need two warrants for one share). These are called “half warrants.”
Some warrants are good for a full share (you need one warrant for one share). These are called “full warrants.”
Obviously, a full warrant is better than half a warrant. You want warrants that can convert into as many shares as possible.
With all this in mind, the best warrant “sweeteners” for private placement investors will have:
–Lower, rather than higher, strike prices. This makes the warrants more likely to go or expire “in the money” and have intrinsic value. If I participate in a private placement at say, $0.50 per share, I’d rather get warrants with a strike price of $1 instead of $2.
–Longer, rather than shorter, expiration dates. This gives the company more time to achieve success and a higher share price… which gives the warrants more time to go or expire “in the money” and have intrinsic value. I’d rather get 3-year warrants than 1-year warrants. I’d rather get 5-year warrants than 3-year warrants.
–Higher, rather than lower, conversion ratios. You want warrants that convert into as much stock as possible. This is why I prefer full warrants.
Freely Tradable Vs. Non-Tradable
Some warrants trade freely on stock exchanges. You can buy and sell them on the open market. Some warrants are not freely tradable. You cannot buy or sell them on an exchange.
Freely tradable warrants are much better than non-tradable warrants for both investors and the company. Freely tradable warrants are better for the investor because they trade freely and there is a real bid-ask market for the warrants.
Free trading shares are also much better for the company issuing the warrants. It expands its base of investors. This is because many fund managers are prohibited from buying stocks under $1 per share (sub $1 stocks are seen as riskier). However, the same fund managers are allowed to buy warrants. Those managers can buy the warrants and become investors in the company.
Whether a warrant is freely tradeable or not depends on whether it is listed or not. In a company’s news release, it will mention something like, “The warrants are listed on the TSX Venture Exchange under the trading symbol XYZ .WT”
A freely tradable warrant will have “.WT” in its symbol.
Ideally, we get warrants that are freely tradable. It’s good to be able to sell the warrants whenever you like on the open market. But you do not have the obligation to sell or exercise the warrants when they are listed. It’s just an extra option for the investor.
The other advantage of a freely tradable (or listed) warrant is that it doesn’t have to be above the strike price to be able to realize a profit.
When a non-tradable warrant has a strike price of$1.00 but the stock is at 75 cents, you wouldn’t want to exercise the warrant. It’s not in the money.
In this situation, a freely tradable warrant still has value. If you wanted to, you could sell the warrant on the exchange. You couldn’t do this with a non-tradable warrant.
The best type of warrant is a free trading, full 5-year warrant with a strike price that is 50% higher than the share price at the time of the financing.
You could think of free-trading full 5-year warrants as the “Ferrari” of warrants.