Stock Options versus Stock Warrants – What’s the Difference?

I frequently hear clients and some of their advisers talk about “stock options” and “stock warrants” and there is often considerable confusion between the two. In this post, I’ll briefly describe the major distinctions between these instruments and how each can be used in a privately held company.

Stock options are issued to key employees, directors and other service providers in exchange for services rendered to the company/employer. Generally, there is a stock option plan under which a set number of options (and often restricted stock) can be issued to one or more key service providers to align their interests with the interests of the employer. The option is a compensatory vehicle that is intended to increase the key service provider’s overall compensation if the company’s stock price increases.

On the other hand, warrants are not compensatory vehicles. Instead, they are issued in connection with the company’s raising of capital, either debt or equity securities, and are used to “sweeten” the deal for the investor. So for example, suppose a technology company is raising capital through a Series A Round and wants to incentivize the first investor who joins the deal by giving it “something extra.” In this case, a stock warrant could be issued to the first investor to purchase X number of shares of the company’s common stock at $Y per share. This stock right is issued in connection with a capital transaction and is designed to increase the overall return on investment to the first investor. This vehicle is properly called a warrant.

Another common example would be a stock warrant issued in connection with a debt transaction. To induce the investor to loan funds to the Company, the company might give the investor a warrant to purchase some number of shares of stock which, from the investor’s standpoint, will hopefully generate a higher total rate of return on the overall transaction.

The tax rules governing options and warrants are completely different. Stock options are compensatory in nature and therefore subject to the rules governing compensatory items. The basic treatment of stock options is as follows (this assumes nonqualified options; special rules apply to “incentive” or qualified options):

  • There is no tax to the employee/service provider on the date of grant of the option and the employee has no tax basis in the option.
  • The exercise price of the option cannot be less than the fair market value of the stock on the date of grant (because of the requirements contained in the Internal Revenue Code section 409A).
  • The employee/service provider is taxed on the spread between the fair market value of the stock on the date of exercise and the exercise price.
  • A subsequent sale of the stock would be a capital transaction taxed at capital gains rates (short-term or long-term depending on the holding period).

For additional information on stock options, see my post on Retaining Key Employees in a Privately Held Company Through Equity Compensation – Part 3: Tax Treatment of Various Plans.

On the other hand, warrants are not compensatory and are generally taxed as follows:

  • A portion of the purchase price associated with the underlying stock or debt deal would be allocated to the warrant so the investor would have tax basis in the warrant (but often a nominal amount).
  • The exercise price of the warrant can be any amount; there is no requirement that it be equal to the fair market value of the underlying stock at date of grant.
  • Upon exercise of the warrant, the investor would pay the purchase price for the shares but, unlike the option, there would be no tax due.
  • Like with an option, a subsequent sale of the stock would be a capital transaction taxed at capital gains rates (short-term or long-term depending on the holding period).

And of course, to state the obvious, you can’t simply change the name of the instrument being issued to change the tax treatment (e.g. calling an instrument issued in connection with services a “warrant” will not change its tax treatment; the “substance over form” rule will require that it be treated as an option and subject to the tax rules for options regardless of its name).

Companies and investors dealing in options and warrants should understand the basic differences and consider the tax consequences when contemplating transactions involving such instruments. And please note that the tax consequences described in these posts are for the most generic instruments and you should consult your own tax adviser in connection with any particular transaction.

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© 2012 Casey W. Riggs — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

Casey W. Riggs About Casey W. Riggs

Casey Riggs is a corporate and business attorney who represents companies of all sizes, from startups to large corporations, and in all stages of the business life cycle, from entity formation through an exit event. Casey also represents many of his clients in estate planning and administration.

You can read more about Casey here.

Comments

  1. Alex, i am pretty sure that non-qualified option can have a strike price less than FMV, but then the option grant itself is a taxable event. 409A does not prohibit a strike price less than FMV. For a qualified option (also called an ISO under the tax code), the exercise price cannot be less than FMV (that is one of the ISO rules). thx.

    • Zach, thanks for your response. My understanding of 409A is that it applies to stock options if they provide for the “deferral of compensation”. And Under regulation 1.409A-1(5), nonstatutory stock options do provide for the “deferral of compensation” unless the exercise price cannot be less than FMV. So, yes, you could structure an option with a below FMV exercise price, but then you’d violate 409A. Here’s the relevant part of the regulation. Do you have a different understanding of this reg?

      A) Nonstatutory stock options not providing for the deferral of compensation.
      An option to purchase service recipient stock does not provide for a deferral of compensation if –

      (1) The exercise price may never be less than the fair market value of the underlying stock (disregarding lapse restrictions as defined in § 1.83-3(i)) on the date the option is granted and the number of shares subject to the option is fixed on the original date of grant of the option;

  2. Jonathan Kwan says:

    Casey,
    Can the exercise price for warrants be less than fair market value?

  3. Yes, so long as the warrant is not issued for services (i.e. as compensation). Most warrants I see are “penny warrants”, meaning the exercise price equals one cent.

  4. Hi guys,

    Quick question: I have some warrants that were issued to me as part of a loan notes offering through my company. It is a private company and the warrants are as Casey describes, “penny warrants”. Based on the material I’ve read in this blog, I assume I do not owe any taxes immediately upon exercise. I will only owe taxes when I sell the stocks once the company IPOs, correct? I do not want to exercise them if I owe taxes right now since the stocks are restricted and I cannot sell them easily.

    Thanks and much appreciated!

  5. Casey Riggs Casey Riggs says:

    Tony,

    We can’t really give specific legal advice to your situation on a blog post board. I’ll just say generally speaking that warrants (not issued for services) would not be taxed upon exercise. Instead, the taxable transaction would be upon sale of the stock (when it would usually be long term or short term capital gain). But you need to consult a tax advisor who can analyze your situation and all the facts and details to confirm this.

  6. I have a question(s), what if you through in a cashless feature for the warrants and stock options? What are the tax consequences on the cashless element of the transaction for the warrants, as well as the cashless feature for the stock option, and does it matter if the stock option is qualified or non-qualified? If so how so?

  7. Assume recent investors in a company have paid $1.00 per share for common stock. The company is doing a new round at that same valuation, with the exception that the lead investor in the new round will also get penny warrants to acquire additional shares. No tax to the investor on the warrants even though they are struck at a penny rather than $1.00?

  8. Jessica P says:

    I’m curious about warrants that are indeed issued for services rendered – non-cash compensaton (for assisting an issuer raising capital for example).

  9. Michael says:

    What is the best method for for valuing warrants that were issued months after ESOs.

    • Fred Myer says:

      For private companies (e.g. start-ups), is there any legal requirement regarding the amount of shares in a raise or debt structure and the associated warrants, assuming an arms-length relationship? For example, say an investor loans $10,000 via a convertible note with 3% interest, 1 year term and ability to convert at $1/share; and in consideration of the low rate and high risk also wants warrants at $5/share. Is the warrant limited to 10,000 shares as in the case of a public company, or can it be any amount, say 1,000,0000 shares?

      Thanks

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