Note: This article is the ninth in an ongoing series for Angel Investors. To learn more about developing the key skills needed to make great investments, download this free eBook today Angel 201: The 4 Critical Skills Every Angel Should Master or purchase our books at Amazon.com.
One of the less understood and seldom used instruments in angel investing is the stock warrant. Warrants are essentially the same as the more familiar stock option. Both are a contractual right to buy a certain amount of stock at some point in the future, at a price agreed upon now. In effect, both are a pure upside play with no downside risk prior to exercise. The two names are simply associated with different contexts.
Options are typically given to employees, often pursuant to a defined option plan which sets out many of their terms. Options used in the employee compensation context are often eligible for preferential tax treatment. By contrast, warrants are more typically used in the context of transactions with third parties (investors, vendors, bankers, partners, etc. rather than employees.) They typically have all their terms built right in the warrant document rather than in a separate plan. This means warrants are generally one-offs that do not draw down any pre-approved pool of shares set aside (the way options do). And, while they can be exercised and held in a way that gets you capital gains, it is not as easy as with incentive stock options that are given to employees in connection with a qualified stock option plan.
In our experience, the most common use for warrants is when they are used as a “deal sweetener” to convince angel investors to invest sooner rather than later in a new round of financing, and they are sometimes used instead of a discount to make convertible notes perform more like equity.
Q: Christopher, why should an angel investor be interested in having stock warrants as part of an investment deal?
Warrants are prized by investors because they give you upside appreciation rights without requiring you to commit any capital. You get a locked-in price at which you can buy any time (i.e., your strike price), but you don’t have to buy (i.e., exercise your warrants) unless the stock price goes above your strike price. You get the benefit of a winner without the risk of committing the associated capital.
Q: When is the ‘right’ time to exercise your warrants?
Generally speaking the best strategy for exercising warrants is to wait until you are sure the company is totally out of the woods (and the warrants will therefore definitely be worth something) and then, once you have made that determination, exercise them as soon as possible to start the capital gains clock running so it hopefully has at least a year to run before any acquisition occurs. That way they are treated as long term capital gains with a preferential rate, as opposed to short term capital gains, which are taxed at the same rate as ordinary income. Put another way, you want to exercise them as soon as you reach the point that you are sure you are going to exercise them. Bit of a tautology, and most people just set them aside until the last possible minute and then exercise them as late as possible. Can be a fine strategy IF you are able to hold the stock for a year. If the company gets bought after you exercise, you can be looking at higher taxes that were avoidable if you had known for the last several years you were going to exercise them.
So why not just exercise them right away? Because you have to spend money to exercise them. If the exercise price is fair market value (FMV) at the time they are granted, that can be real money - equivalent to simply investing in the company at that price. True, if the warrants are issued way below FMV, say for a penny each, then you might as well exercise them right away, because it costs you next to nothing to do it. But if they are issued at FMV, and FMV is a buck or two a share, it would cost money to exercise them. Unless you know the company is going somewhere for sure, why pay for what would otherwise be a free chance to wait and see?
Q: In most cases, warrants have a void date 5 to 10 years in the future. How do you keep track of your warrants so you don’t forget to exercise them when the opportunity is right?
Ah, here is the wellspring from which all warrant misery flows. Warrants expire and many people forget about the expiration date. Even if the company remembers, it is under no obligation to tell you (in fact, it already told you, right on the face of the warrant under the clause about expiration date!) Many experienced angels with a lot going on in their portfolio outright forget they even have warrants in a deal, let alone which round they are associated with and when they expire. When we were building and market-testing Seraf, we heard many tales of woe about forgotten warrants. Even if you put them in a calendar, you can forget about them; who keeps the same paper or electronic calendar system for 10 years?
So we knew we needed to build a robust date tracking system into Seraf that not only allows you to see all your key dates, it allows you to set custom reminders to alert you in advance of any key dates you choose. So, for example, when I get warrants, I always note the ultimate expiration date but I also set reminders to myself to check on them and see if it is time to exercise them. Nailing a profitable exercise of a pile of “in the money” warrants you would have otherwise totally forgotten about can pay the lifetime price of Seraf hundreds of times over!
Want to learn more about building an angel portfolio and developing the key skills needed to make great investments? Download Angel 101: A Primer for Angel Investors and Angel 201: The 4 Critical Skills Every Angel Should Master for free, or purchase our books at Amazon.com.