Your smooth selling technique has worked and he's ready to plunk some of his hard-earned cash into your business. Then, from out of nowhere, he demands that you thrown in some warrants as part of the deal. Warrants? What are they?

Investors often look at warrants as deal sweeteners, a little added incentive that motivates them to invest in a business. But unlike other incentives, a warrant only benefits the investor if the company grows.

Warrants 101

A warrant is similar to a stock option in that it gives the investor the option to purchase stock at a fixed price that is always higher than the price of the stock at the time it is issued. If the owner of the warrant exercises it before its term has expired, he can then turn around and sell the stock for a quick profit. However, the investor can only make money if the value of the stock exceeds the exercise price established at the time the warrant is issued.

Sound confusing? Suppose a business with a current stock value of $5 per share issues an investor a five year warrant with an exercise price of $10 per share. At some point during that five year period the value of the stock climbs to $15 a share. When that happens, the investor can exercise his option by purchasing stock at the $10 warrant price. If he subsequently sells the stock at the market rate of $15, he has turned a profit of $5 a share.

But what happens if the stock never exceeds the $10 per share warrant price during the warrant term? The short answer is nothing happens. For example, if the stock never goes above $8 per share, the investor's best option is to purchase the stock at the $8 market price rather than exercising the warrant to purchase it at $10. If the warrant term expires before the stock price exceeds the exercise price, the investor has missed his opportunity to benefit from the warrant.

Warrant Terms

The most significant difference between a warrant and a traditional stock option is the length of the contract. Stock options are typically issued for short durations, usually measured in months rather than years. Warrants, on the other hand, are usually long term contracts. It's possible to issue a warrant for a duration as long as fifteen years. The longer the term, the more attractive the warrant will be to investors.

Transferability

Warrants also have another important characteristic that makes them attractive to investors: Transferability. If it is beneficial for them, investors can sell a warrant to a third party. The price of the sale is completely determined by the warrant's owner and the purchaser. Warrants on stocks with a value close to or exceeding the exercise price as well as those with significant time remaining on their term are most valuable and command higher prices than warrants that are unlikely to surpass their exercise price before their terms expire.