What Is Warrant Coverage?

Warrant coverage is an agreement between a company and one or more shareholders where the company issues a warrant equal to some percentage of the dollar amount of an investment. Warrants, similar to options, allow investors to acquire shares at a designated price.

Warrant coverage agreements are designed to sweeten the deal for an investor because the agreement leverages their investment and increases their return if the value of the company increases as hoped.

Understanding Warrant Coverage

Warrant coverage assures investors that they can increase their share of ownership in the company should circumstances rapidly improve. This is done by means of issuing warrants as a condition of the investors' participation.

A warrant is a type of derivative that gives the holder the right to buy the underlying stock at a specified price before or at maturity. The warrant does not obligate the holder to purchase the underlying stock. A warrant coverage is simply the agreement to issue stocks to cover the possible future execution of the warrant instrument.

Warrants are similar to an option but have three main exceptions. First, they originate from a company, not from traders. Second, warrants are dilutive to the underlying stock. When the holder exercises a warrant, the company issues new stock, rather than delivering existing stock. Finally, they can be attached to other securities, most notably bonds, giving the holder the right to purchase shares of stock, as well.

Reasons for Warrant Coverage

Warrant coverage allows and possibly encourages the holder to participate in the success of the company, manifested in the appreciation of the price of the underlying stock.

It also gives the holder protection against the dilutive effects of any future new share offerings. This future protection is ironic because the exercise of the warrant is dilutive itself to the existing shares.

One reason a company might issue warrants is to attract more capital. For example, if it cannot issue bonds at a satisfactory rate or amount, warrants attached to a bond can make them more attractive to investors. Often warrants are seen as speculative.

One of the best examples of warrant coverage took place during the financial crisis of 2008. Wall Street giant, Goldman Sachs, needed to increase capital and raise the perception of its financial health.

Goldman sold $5 billion of preferred stock to Warren Buffett's Berkshire Hathaway, Inc. The warrants to purchase $5 billion of common stock with a strike price of $115 per share had a five-year maturity. Goldman's shares were trading near $129 at that time, giving Berkshire an instant, although not guaranteed, profit.

Example of Warrant Coverage

For example, an investor purchases 1,000,000 shares of stock at a price of $5 per share, totaling a $5,000,000 investment. The company grants a 20% warrant coverage, and issues to the investor $1,000,000 in warrants. In technical terms, the company guarantees 200,000 additional shares at an exercise price of $5 per share.

Issuing warrants does not give the investor any additional downside protection, as the underlying shares would be issued at the same price they paid for the stock; however, the warrant coverage would give the investor additional upside, if the company goes public or is sold at a price above $5 per share.