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.
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.