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Warrants vs Options: A Brief Guide
by Jennifer Kiesewetter
TLDR
- Two types of equity grants include stock warrants and stock options. Stock warrants are “options issued by the company that trade on an exchange and give investors the right (but no obligation) to purchase company stock at a specific price within a specified time period.” Stock options, on the other hand, are contracts “between two parties that gives the buyer the right to buy or sell underlying stock at a predetermined price and within a specified time period.”
- Stock warrants are opportunities to purchase startup stock within a certain period of time at a set price. Note that warrants are opportunities to purchase stock; the decision to purchase or not purchase is left to the investor. However, the warrant itself does not equate to actual ownership in the startup. Instead, it represents the right to purchase ownership under pre-defined terms. When an investor decides to exercise a warrant, they purchase startup stock, and the proceeds contribute to the startup’s capital.
- Warrants are often issued during early financing rounds – such as pre-seed or seed stages. Issuing warrants can encourage investors to invest at these early stages before you have the capital to satisfy ownership percentages.
- Stock options are issued to investors when the stock price is expected to rise or fall. The seller of the stock (or the startup) is called the option writer or the optioner. The recipient of the stock option is called the optionee. Note that a stock option does not entitle the investor to any rights normally held by stockholders, such as voting rights or the right to dividends. The only thing that stock options provide is the opportunity to purchase stock in the future.
- Startups may choose to issue stock options for several reasons, such as no present cust to the investors or employees and no current tax ramifications (as receiving options is not a taxable event). This tax-favorability is very favorable to employees, who won’t face immediate tax consequences as they would with common stocks.
As a startup grows and scales, you may decide to offer equity to employees, leadership, advisors, or investors – or all of the above.
Two types of equity grants include stock warrants and stock options. Stock warrants are “options issued by the company that trade on an exchange and give investors the right (but no obligation) to purchase company stock at a specific price within a specified time period.”
Stock options, on the other hand, are contracts “between two parties that gives the buyer the right to buy or sell underlying stock at a predetermined price and within a specified time period.”
To learn more about equity options, keep reading to learn the in’s and out’s of warrants and options.
What Are Stock Warrants?
Stock warrants are opportunities to purchase startup stock within a certain period of time at a set price. Note that warrants are opportunities to purchase stock; the decision to purchase or not purchase is left to the investor.
However, the warrant itself does not equate to actual ownership in the startup. Instead, it represents the right to purchase ownership under pre-defined terms.
When an investor decides to exercise a warrant, they purchase startup stock and the proceeds contribute to the startup’s capital.
Two types of warrants exist: call warrants and put warrants. A call warrant is “the right to buy shares at a certain price in the future.” A put warrant is “the right to sell back shares at a specific price in the future.”
Warrant certificates are issued upon grant. The certificate includes the warrant’s terms, such as the time period in which investors can exercise the warrant and the price upon exercise.
Let’s look at an example:
Suppose you offer a warrant with an exercise price of $10 on your startup stock which is currently trading at $8. The warrant expires in two years and is currently priced at $1. Then, assume that eighteen months later, the stock trades at $15 per share. In this case, the warrant is now worth $5 (the difference between the current price and the exercise price). However, if after eighteen months, the stock trades at $8, then the warrant has no real value to the investor.
When Is It Helpful to Issue Warrants?
Warrants are often issued during early financing rounds – such as pre-seed or seed stages. Issuing warrants can encourage investors to invest at these early stages before you have the capital to satisfy ownership percentages.
For example, say there’s an investor that would like to invest $500,000 in your startup, but your seed round is limited to $250,000. In this case, you can issue warrants for $250,000, becoming exercisable only if the investor contributes according to your agreement. This way, you can close your fundraising goals while incentivizing investors.
You can also offer warrants to third parties, such as startup incubators or advisors. This way, you’re incentivizing these parties in exchange for their talent, experience, and services.
What Are Stock Options?
Stock options are issued to investors when the stock price is expected to rise or fall. The seller of the stock (or the startup) is called the option writer or the optioner. The recipient of the stock option is called the optionee.
Similar to warrants, stock options come in two forms: call options and put options. A stock call option “grants the purchaser the right but not the obligation to buy stock. A call option will increase in value when the underlying stock price rises.” On the other hand, a stock put option “grants the buyer the right to sell the stock short. A put option will increase in value when the underlying stock price drops.”
For example, if s stock is valued at $50 and an investor believes that the price will rise to $65 over the next few weeks, then they could purchase the stock option for $50 (the “call option”). Then, the investor could sell the stock at $65, making a profit of $15. This profit is called the “premium.”
Additionally, stock options can be non-qualified stock options (NSOs) or incentive stock options (ISOs). NSOs are “type[s] of stock option[s] used by employers to compensate and incentivize employees. It is also a type of stock-based compensation.” ISOs, on the other hand, are “type[s] of compensation given to employees, usually part of a broader compensation plan. ISOs can only be given to participating employees and can only be granted under defined limits.” One significant difference between ISOs and NSOs is that ISOs qualify for special tax treatment.
Note that a stock option does not entitle the investor to any rights normally held by stockholders, such as voting rights or the right to dividends. The only thing that stock options provide is the opportunity to purchase stock in the future.
When Is It Helpful to Issue Options?
Startups may choose to issue stock options for several reasons, such as no present cust to the investors or employees and no current tax ramifications (as receiving options is not a taxable event). This tax-favorability is very favorable to employees, who won’t face immediate tax consequences as they would with common stocks.
Warrants vs. Options
Let’s now look at the main differences between stock options and stock warrants. Options and warrants are similar in that they both give the investor the right to buy or sell stock at a point in the future for (or based on) a set price.
However, warrants differ from options in two significant ways: (1) a startup will issue its own warrants; and (2) the startup issues new shares of stock for each warrant issued. These warrants serve as a source of future capital for the startup. Warrants are typically issued to investors, banks, or third parties that contribute commercially or financially.
On the other hand, stock options are listed on public stock exchanges. Additionally, they are issued to service providers, such as employees or contractors.
Stock options don’t typically last as long as warrants, with most stock options existing from a few months to a few years and warrants existing for upwards of 10 to 15 years.
Depending on your startup's needs, you may choose to issue both. Warrants for long-term investments and options for shorter term investments.
The Benefits of Warrants
Warrants have numerous advantages. Some include the exercise date is far off, so holders can plan for taxes. Additionally, the strike price of the warrant may be adjusted up or down based on the payment of dividends. Further, warrants provide huge upside potential for both investors and startups.
The Disadvantages of Warrants
Like any equity award, there are disadvantages to consider as well. First, warrants can be volatile, creating higher risk for investors. Additionally, warrants aren’t as popular in the United States as in other countries, such as China. Finally, warrants can often be more complex instruments due to their price adjustments. Warrants aren’t created equal – adding to their confusion and complexity.
The Benefits of Options
Now let’s look at the benefits of issuing stock options. Stock options give employees the opportunity to have startup ownership, encouraging them to feel more like owners with a direct connection to the business and its success. Stock options are also ideal to offer as part of employee compensation packages, helping startups to attract and retain top talent.
Options can also contribute to employees’ investment plans, helping to create a long-term investment strategy. Further, with stock options, employees potentially enjoy tax benefits while paying no investment broker fees.
The Disadvantages of Options
Now let’s look at some disadvantages of issuing stock options. For employees, the tax consequences tend to be complicated, despite the opportunity to receive favorable tax benefits. Because of this confusion, employees would more than likely have to hire a certified public accountant or investment advisor to help them account for the options.
Additionally, stock option holders can experience dilution. For example, stock dilution can occur when option holders exercise their options. As issued stock shares increase in number, each stockholder experiences a dilution in their ownership, making each share of stock less valuable.
Finally, the value of the stock options depends solely on the startup’s collective performance – not the employee’s individual contribution. Some hard-working option holders may resent those not as focused on achieving results.