Share warrants are a common source of funding used by companies, both public and private. As is clear from the nomenclature, warrants are issued with an option to convert into shares of the company. Having said so, share warrants are not similar to CCDs or ESOPs as has been explained further in this write-up. In the United States, warrants are also referred to as ‘sweeteners’ since they serve as an enticement to attract potential investors to invest in the company.
One common confusion which persists among investors is that share warrants are similar to bearer shares referred to in sections 114 and 115 of Companies Act, 1956 (‘Act, 1956’). The warrants referred to in erstwhile Act, 1956 were similar in concept to the warrants referred to in Companies Act, 2006 in United Kingdom. Such warrants were in the nature of bearer shares. However the concept of bearer warrants as envisaged therein is also set to become extinct1. The share warrants, which is the subject matter of discussion in this write-up is similar to the concept of stock warrants used in United States.
We now attempt to answer certain basic queries pertaining to the issue of share warrants.
1. What is a share warrant?
Share warrant is an option issued by the company that gives the warrant holder a right to subscribe equity shares at a pre determined price on or after a pre determined time period.
2. Whether share warrant is a security?
As per Section 2(h) of Securities Contract Regulation Act, 1956“securities” include—
(i) shares, scrips, stocks, bonds, debentures, debenture stock or other marketable securities of a like nature in or of any incorporated company or other body corporate;
(iii) rights or interest in securities;
Further since the underlying instrument in warrants is equity shares which in turn are marketable securities, it is but obvious that warrants will also be marketable in nature.
Further vide RBI vide Notification 2No. FEMA. 308/2014-RB2 dated June 30, 2014 RBI clarified that warrants shall be treated as security within the meaning of Section 2(za) of FEMA3.
3. Why is it beneficial for the issuer to issue warrants?
If the issuer issues the shares right away, the issuer will get the current pricing. The warrant, on the other hand, defers the issuance of the shares to a future date, while at the same time raising capital immediately. Therefore, the issuer may take advantage of future appreciation in the price of the stock.
4. With whom is the option vested?
Looking at the nature of share warrants it is but obvious that the option to exercise is with the option holder.
5. Whether it is mandatory on the part of warrant holder to subscribe to the equity shares?
The warrant holder is given a right but not an obligation to subscribe equity shares. In case he does not exercise his right, the option will lapse. Further, as per Regulation 4 of ICDR, 2015, if the option holder does not exercise the option to convert his options into equity shares, then the consideration paid upfront will stand forfeited.
6. What does the warrant holder pay?
The warrant holder partly pays the premium for the option which he purchased and partly pays the price for the share that ultimately will get allotted to him if he exercises the option. The percentage of the entire consideration which is to be paid upfront has not been prescribed in Companies Act, 2013. Hence it is up to the company to decide the price to be paid upfront. In this regard it is pertinent to note for the purpose of reference that Regulation 4(3)(c) of ICDR, 2015 requires at least 25% of the consideration amount has to be received upfront.
7. How is the element of premium treated in the case of share warrants?
It is important to understand that there are multiple elements attached to the issue of share warrants. For example suppose share warrants are issued for a consideration of Rs. 100/- for equity shares of Rs. 10. Further, the terms of issue require 25% of the total consideration to be paid upfront. Hence Rs. 25 which is paid upfront by any potential investor is in the nature of an option premium since it only entitles him to receive the share warrant. Rs. 25 does not constitute the share premium. This option premium will form a part of the net worth of the company. Of the remaining Rs. 75, Rs. 65 is the actual premium on shares considering that the face value is Rs. 10. Hence there is a clear line of distinction between option premium and share premium.
8. What happens if the warrant holder does not exercise the option to take equity shares?
This is left for the Board to decide since the Act, 2013 does not prescribe anything specific in this regard. Regulation 4(3) of ICDR, 2015 states that the initial premium amount paid will stand forfeited.
9. In case of FDI investor, if the investor later does not exercise the warrant, what will happen to the premium paid?
In absence of specific provision under FEMA regulations, it is up to the Board to decide on the terms of issue of warrants in this regard. As mentioned above, the Board may resolve that the amount of premium which was paid by FDI investor at the time of granting of option will get forfeited on similar lines as Regulation 4(3) of ICDR, 2015.
10. What does the warrant holder get in lieu of the premium he pays?
In option theory every option has a value based on the difference between the fair value of the share at the time of the exercise of the option, and the strike price, that is, the price at which the option is granted. Therefore, if the share appreciates in value, the option/warrant holder stands to gain. It is stated in option theory that more the volatility of the underlying share more is the chance for making a gain.
11. How is the amount of option premium determined?
There are well understood option finding techniques such as Black Scholles Model, Binomial Options Pricing Model to determine amount of option premium that can be charged.
12. What if the option is ultimately not exercised by the warrant holder?
Regulation 4 of ICDR, 2015 states that if the option holder does not exercise the option to convert his options, then the entire consideration will be forfeited. However, the provisions of ICDR, 2015 are applicable only to a listed company. Other companies can decide on their terms under such circumstances. In case the company has received the balance consideration of 75% in tranches, then the terms can allow the option premium to be forfeited. Further since the shares have not been allotted to the potential investor, the element of premium on shares can be refunded.
13. Does the right of the warrant holder to get equity shares in future dilute the current earnings of the Company?
Earnings of the company are denominated by earning per share (EPS) which is calculated by dividing Profit after Tax by the number of shares outstanding. Since on conversion number of outstanding shares will increase, hence to show the correct performance dilutive EPS needs to be shown which assumes exercise of all outstanding warrants or options allotted.
14. How are warrants different from Compulsorily Convertible Debentures (CCDs)?
Under CCDs there is a certain conversion into equity, and is therefore, in the nature of a deferred equity whereas warrants are options where the option to exercise lies with the warrant holder. Therefore, a warrant may expire without conversion into shares. Hence, if the company does not do well, it may gain by issuing warrants instead of CCDs. The position of the issuer in case of a warrant is that of an option, whereas the nature of a CCD is a forward. As in case of an option, the call option writer stands to gain if the share prices moves down.
15. Can interest be paid on warrant until converted?
There is no question of payment of interest on warrants. However, in case of CCDs interest may be paid.
16. Are ESOPs similar in nature to share warrants?
Intuitively the answer may be a yes since both the instruments offer shares. However having said so, the cardinal difference between the two is that ESOPs are compensatory in nature. It is not that every employee of the company is entitled to receive ESOPs. The privilege is given only to a chosen few. On the
other hand, share warrants are in the nature of instruments used by genuine investors to invest in the shares of the company.
17. Will the amount raised by issue of warrants be counted for calculating net worth?
As per Section 2(57) of Act, 2013 “net worth” means the aggregate value of the paid-up share capital and all reserves created out of the profits and securities premium account, after deducting the aggregate value of the accumulated losses, deferred expenditure and miscellaneous expenditure not written off, as per the audited balance sheet, but does not include reserves created out of revaluation of assets, write-back of depreciation and amalgamation.
In case of warrants issued at a premium, the holder partly pays the premium for the option which he purchased and partly pays the price for the share that ultimately will get allotted to him. The amount of share premium received will form a part of securities premium account.
Money received against share warrants are disclosed separately in the balance sheet under ‘Shareholder funds’ and does not form part of paid-up share capital unless converted into shares.
18. Where is the amount received against share warrants shown in the Balance sheet?
For accounting purposes, the amount received against share warrants shall be shown under the head Shareholder’s funds on the liability side.
19. What procedural compliances a company needs to ensure for issue of share warrants?
Since share warrants are regarded as security, company needs to ensure compliance of Section 23 and other applicable provisions of Chapter III Part I in case of public issue of warrants, Section 42 for issue on private placement basis and Section 62 (1) in case of a rights issue and Section 62 (1) (c) and Section 42 in case of preferential issue of warrants.
In case of public issue of warrants, provisions of SEBI (ICDR) Regulations, 2009 as amended from time to time also needs to be complied with. Further, in case warrants are being issued to person resident outside India – compliance under FEMA (Transfer or issue of securities to a person resident outside India) Regulations, 2000 as amended from time to time needs to be ensured.
20. In case a Company has bought back equity shares recently and a period of 6 months has not elapsed, can the company allot shares for conversion of warrants?
As per Section 68 (8) of Act, 2013 the Company can allot shares for discharging the subsisting obligation of conversion of warrants.
21. What conditions are prescribed in SEBI (ICDR) Regulations, 2009 for issue of warrants?
Regulation 4 (3) of SEBI (ICDR) Regulations, 2009 permits issue of warrants along with public issue or rights issue of specified securities subject to following conditions:
a. tenure of such warrants shall not exceed 18 months from the date of allotment in the public/ rights issue;
b. not more than one warrant shall be attached to one specified security;
c. the price or conversion formula of the warrants shall be determined upfront and at least 25% of the consideration amount shall also be received upfront;
d. in case the warrant holder does not exercise the option to take equity shares against any of the warrants held by him, the consideration paid in respect of such warrant shall be forfeited by the issuer.
Further, Regulation 72(3) which pertains to ‘conditions for preferential issue’ states that in case promoter and promoter group has previously subscribed to warrants of an issuer but failed to exercise the warrants, then the promoter(s) and promoter group shall be ineligible for issue of specified securities of such issuer on preferential basis for a period of one year from:
a. the date of expiry of the tenure of the warrants due to non-exercise of the option to convert; or
b. the date of cancellation of the warrants, as the case may be.
22. At what point of time the amount of consideration shall be paid in terms of SEBI (ICDR) Regulations, 2009?
Regulation 77 (2) of SEBI(ICDR)Regulations, 2009 mandates that an amount equivalent to 25% of the consideration determined in terms of regulation 76 is to be paid against each warrant on the date of allotment of warrants. The balance of the consideration shall be paid at the time of allotment of equity shares pursuant to exercise of option against each such warrant by the warrant holder.
23. At what point of time the amount of consideration shall be paid under the provisions of FEMA regulations?
Under FEMA provisions the amount of consideration payable upfront is the same as stipulated under SEBI (ICDR) Regulations, 2009 i.e. 25% of the consideration.
Price at the time of conversion shall not be less than fair value at the time of issuance but can surely be more than the pre-agreed price.
3 2 (za) “security” means shares, stocks, bonds and debentures, Government securities as defined in he Public Debt Act, 1944 (18 of 1944), savings certificates to which the Government Savings Certificates Act, 1959 (46 of 1959) applies, deposit receipts in respect of deposits of securities and units of the Unit Trust of India established under sub-section (1) of section 3 of the Unit Trust of India Act, 1963 (52 of 1963) or of any mutual fund and includes certificates of title to securities, but does not include bills of exchange or promissory notes other than Government promissory notes or any other instruments which may be notified by the Reserve Bank as security for the purposes of this Act.
4 Refer the relevant write ups – Government allows partly paid shares and warrants for FDI, by Vinita Nair ,16 September, 2015 & RBI eases FDI norms – permits investment in partly paid shares and warrants, by Vinita Nair and Debolina Banerjee, 17th July, 2014
(Article is Authored by Aman Nijhawan, CS Nivedita Shankar and CS Vinita Nair of, who are associated with Vinod Kothari & Co.)