There’s a Warrant Out for Your Success
Dear Penny Stock Millionaire,
I believe most penny stock companies are sketchy. I know that sounds bad, but I like transparency. If you assume most of these companies will fail, then you won’t fall for the hype…
The irony is, the sketchy nature of many micro-caps can create opportunities for traders. And there are two conflicting sides…
First, you have degenerate gamblers who buy anything spiking premarket. Or the chasers who haven’t learned not to buy overextended stocks. They say, “Oh, it’s gonna spike, it’s gonna spike.”
These traders are like the hyenas in that famous children’s movie about lions…
Then you have the short-sellers. They say, “There are warrants, there are warrants.”(Don’t worry I’ll explain those in a minute) They’re the party poopers — they short anything that’s up.
You can potentially have a nice trading career living in between the two opposing sides. You just have to learn how you can take advantage of the situation. Which brings me back to stock options and warrants.
The Difference Between Stock Options and Warrants
Both employee stock options (ESOs) and warrants give the owner the right to buy shares in the company. But there are some fundamental differences.
What’s an Employee Stock Option?
A stock option gives the employee the right, but not the obligation, to buy a set number of shares, at a set price, within a predetermined period of time.
For many employees of growth-stage companies, the stock option is the crème de la crème of compensation. Why? Because if they work hard and the company goes public, they stand to get a nice payout. Or, if it’s already a publicly traded company, their hard work might lead to an increase in share price. Either way, they have an incentive to work hard.
(Note: Sometimes these kinds of options are referred to as incentive stock options or ISOs.)
How Stock Options Work
Say, for example, you get a new job. Your pay package grants you 20,000 stock options that vest over four years, starting in year two. That means you can buy a certain number of shares each year at the strike price and sell them at the market price. Of course, you’d only do this if the current price was higher than your stock option strike price.
For our example, let’s say the strike price is $5 and the stock options vest like this:
- Year 2: 2,500 shares.
- Year 3: 2,500 shares.
- Year 4: 5,000 shares.
- Year 5: 10,000 shares.
And when it’s time to exercise your options in year two, the market price is $5.50. You decide to exercise the option — buying 2,500 shares at the $5 strike price and selling them all at the $5.50 market price. That’s a tidy profit of $1,250.
Some ESOs allow an exercise-and-sell option where you don’t even have to put up your own money. With this option, the brokerage handling the transaction covers your upfront costs.
You could also hold the options. But be aware that U.S. tax law requires you to exercise your ESOs within 10 years of issue.
The other alternatives are to exercise and cover, or do nothing. Exercise and cover means selling only enough shares to cover the purchase. You’d hold your remaining shares for potential future gains.
Key Stock Option Takeaway
The key thing to remember as we move on to warrants is that stockoptions give you the right to purchase existing shares. Because they already exist, they’re ‘priced in’ to the company’s share price.
What Are Warrants?
When warrants Stock warrants, issued by the company, give the holder the right to buy shares directly from the company are exercised, shares are added to the float.
Now we descend into the murky depths…
Remember: Your focus should be on learning how things work. Why? So you can learn how to potentially take advantage of market inefficiency.
Also, I’ve simplified things for this post.
There are varieties of warrants and stock options. For trading purposes (especially short selling) you should understand warrants. This post is only a start. You also need to learn to read Securities and Exchange Commission (SEC) filings.
How Warrants Work
Warrants are technically similar to stock options. But there are some key differences.
How Stock Options and Warrants Differ
- Warrants are issued directly by the company.
- They’re tied to an underlying security that doesn’t yet exist.
- Because warrants are tied to nonexistent securities, they’re dilutive.
- Warrants are often attached to new shares offered in a financing.
Now let’s take a look at each difference in a little more detail…
Warrants Are Issued by the Company
Companies issue new stock and stock warrants to raise capital. While we’d all like to think raising capital means the company can continue R&D on their latest world-changing invention…
… too often it’s a sign the company has little cash, minimal revenue, and needs the financing to keep the lights on. Or to pay the executive salaries. Screw being nice — it’s usually to pay the executive salaries and consulting fees.
Warrants and Related Shares Created Out of Thin Air
So, for example, say yesterday a company’s float was 10 million shares. Today 2 million new shares appear on the market after warrants are exercised. Now there are 12 million shares.
What do you think that does to the price of the stock? Let’s say the company had a market capitalization of $10 million. Prior to the new shares hitting the market, each share was worth $1. But now there are 12 million shares.
Is the company worth $12 million?
Warrants Are Dilutive
Without something to drive the price up, the answer is no. All things being equal, the share price would drop to 83.3 cents per share. ($10 million divided by 12 million shares equals .833 or 83.3 cents per share.) This is what I mean when I say warrants are dilutive.
Warrants and SEC Filings
If you’re wondering about the legality of warrants … I assure you, they’re legal. Sketchy? Likely. Even ethically questionable once you see how they work, but legal.
So long as the company reports the warrants properly, they’re fair game.
This is where market inefficiency comes into play. Most people won’t take the time to read the filings. Instead, they’ll read the email from the pumper, verify it on Twitter, and then call their broker and order a few thousand shares before the ‘next Microsoft’ launches them into the top 1%…
OK, I’m being facetious. Like I said, the company is required to report the creation of warrants. What’s the best way to let the world know what you’re doing without jeopardizing your chance to raise capital?
Bury it in an SEC filing. The first thing to look for if you’re wondering about new shares is an S-1 filing. The S-1 is a registration of new shares with the SEC. It’s required before the shares can be traded on an exchange.
But to really get a clear picture, you need to dig further…
Look for information on how the shares will be offered. What’s the exact number? Will there be warrants? What’s the exercise price? You can find this information in SEC form 424B4 — which is an update to the prospectus filed before the IPO.
Pump It Up, Baby!
When a company needs to raise money, one option is to increase the number of shares. This requires approval by the board of directors. When the stock price is right, they sell the shares on the open market.
When you see a company with an S-1 filing, they’re offering new shares. Any such offering dilutes the value of existing shares. Why? Because the public float increases by the number of new shares sold.
When you add warrants to the mix, it only gets more complex and sketchy. That’s because the warrant holder has the right to purchase shares at a set price, but the shares don’t exist until the warrants are exercised.
Tomorrow I’ll go over a case study to show you exactly how all of this plays out in the market. Stay tuned.
Editor, Penny Stock Millionaires