Stock Warrants vs Options: Breaking Down the Differences

The equity granted by companies to shareholders and optionholders can come in many forms. Warrants and options are both commonly used in private and public companies alike. For the purposes of this article, we're going to focus on the use of warrants and options in private companies.

Most companies grant stock options of some kind as they grow. Warrants are less widely used overall than stock options, but they can play a valuable role for businesses who want to create additional incentives for investors and lenders in corporate transactions. Let's take a look at how warrants and options compare.

What is a stock warrant?

A stock warrant represents the right (but not the obligation) to buy shares in a company at a specified price, at a specific date in the future (often called the 'expiration date'). Warrants are issued by companies, and are often used in commercial financing and investment transactions.

Warrants are not immediately recognised as equity on the cap table, but the holders of warrants are able to convert their warrants into equity at the expiry date. This makes stock warrants a useful form of collateral in a fundraising round, for instance, or in a lending agreement with a bank.

Don't confuse warrants with convertible notes, though. A convertible loan note is designed to let the holder of the note convert debt into equity depending on whether particular conditions of the original agreement are met. A stock warrant, in contrast, can sit alongside debt in a transaction like a bank lending agreement.

What is a stock option?

A stock option represents the optionholder's right to buy a share in the company at a point in the future. Options vest over time (as do warrants) – commonly, optionholders face a 'cliff' of 12 months before they earn any rights to their equity. Then, companies open up windows during which optionholders can exercise their right to turn their options into shares, paying the exercise price (which is also called the strike price) to do so.

Key differences

Stock options and warrants share some similarities, but there are also important differences between options and warrants to be mindful of.  

Discount to market value

Employee stock options can generally be granted at a discount to market value. Warrants, on the other hand, must be purchased at a share price which represents current fair market value. However, warrants appeal to investors and other stakeholders because the specific price of each warrant remains the same through to the exercise date. The fixed price means that the more the company stock grows in value over time, the more warrant-holders stand to gain from their warrants.

Dilution

In a public company, when options are exercised, no new shares are created, so there isn't an automatic dilutive impact for the company's other shareholders. In private companies, though, neither employee stock options nor warrants are accounted for on the cap table until they're exercised. When an investor or another entity exercises their stock options or warrants, the number of shares outstanding changes and other shareholders are diluted.

The difference is the way in which warrants are useful as an anti-dilution hedge for investors. If an existing investor holding warrants is to be diluted in a new round of funding, they may choose to exercise their warrants in order to maintain their ownership percentage in the company.

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Types of transaction

Stock option grants are conventionally made to employees and other individuals who are performing a service for the company – this might include advisors. On the other hand, warrants are often used to grant ownership stakes to corporate entities like investors, banks or other companies.

Warrants are used in this way because their structure gives the issuing company additional flexibility when agreeing investment terms. For instance, a stock warrant can compensate investors who are cautious about committing the entirety of a new investment in cash. However, this isn't the only use case for warrants. Companies can issue warrants to employees in certain circumstances, and they are particularly widely used in Scandinavian countries.

Warrants can be issued as common or preferred stock, and the issuing company needs to specify the share class the warrant falls under. Here is an example of a warrant plan sitting alongside other employee stock option plans on a Ledgy dashboard:

When employees exercise their warrants as part of an employee stock ownership plan, they pay the difference between the strike price and the fair market value of the warrant at time of exercise.

Learn more about employee stock ownership plan management software.

Transferability

While it's possible to transfer ownership of a stock option through company-sanctioned processes like secondary share sales, in practice it is difficult and unusual – and often impossible, depending on the company's legal documentation – for employees to transfer ownership of their stock options outside extraordinary events like secondaries.

It is easier for investors to build in transferability conditions into warrants, and companies should take care to understand the potential ramifications of transferable warrants, as transferring exercisable warrants could mean new shareholders on your cap table.

Stock warrants vs options: which is best for your company?

Companies will often deal with both stock options and warrants as they scale. Companies should carefully consider how stock options and warrants can be used to best effect.

Warrants can be a valuable tool to incentivise investors or lenders to participate in transactions that inject startup or growth capital into the business. Warrants help their holders mitigate the effects of dilution through subsequent funding rounds. However, warrants have different effects on the cap table compared to share options, including the way exercised warrants impact dilution.

FAQs

Where do warrants sit on the cap table?

As stock warrants have the potential to turn into equity stakes in the future, they need to be represented on the cap table. Depending on how you're using warrants, they may need to be located in the employee equity pool, or listed as investors' securities. Failing to properly structure warrants on your cap table risks creating confusion further down the line.

How do I determine the fair value of warrants?

As with other forms of derivatives and equity securities, you can calculate the fair intrinsic value of warrants using the Black-Scholes model.

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