Setting the strike price for a warrant

If you decided to issue warrants, as opposed to the more tax efficient QESOs (find out which to use here), one of the most important aspects is what strike price you should set. The strike price is the price per share you pay when you use the warrants to buy shares. It also effects the price you pay for the warrant at the beginning of the warrant program; this is often called the warrant premium.

In the Money

If, at the end of the warrant program, the value of the share is higher than the strike price, then the warrant is said to be in the money and it makes sense to use the warrant to buy shares. So the lower the strike price, the higher the likelihood that the warrant will be in the money. And a lower strike price also requires you to pay less for the shares. If you have 10,000 warrants at a strike price of 20 kr, you have to pay 200,000 for the shares (20 * 10,000 = 200,000). But if the strike price is 50 kr, you have to pay 500,000 kr (50 * 10,000 = 500,000).

The Catch with a Low Strike Price

This makes it easy, one may think: Aim for the lowest possible strike price. However, there is a catch. The lower the strike price, the higher the warrant premium. The warrant premium is calculated using the Black-Scholes formula, and besides the length of the warrant program and the volatility, the strike price is perhaps the most important parameter determining the price. The Black-Scholes formula is not at all intuitive, but the general idea is that the lower the strike price, the higher the warrant premium, and conversely, a high strike price gives a lower warrant premium. If you want to play around with it, it is built into the StartupTools platform and also available as a google spreadsheet.

Ideally, you would want a strike price which is as low as possible. The problem is that the lower it gets, the more expensive the warrant becomes. At the extreme – if you set the strike price at zero (or rather the quota value, which is almost but not quite zero), then the price of the warrant is equal to the current price of the stock, which means that you might as well buy the stock right away.

Examples

Here is an example of what the warrant premium becomes at different strike prices for a four year warrant program. We assume that the company has 2.5 million shares to start with, and that the current valuation is 50 million kr, that is 20 kr per share. We also assume that the volatility is 30% and the risk free interest rate is 1.81% (the actual rate when this article is written). Further we assume that we issue 25,000 warrants, corresponding to 1 % of the shares.

Strike Price Per Share20 kr30 kr40 kr
Price per warrant5.28 kr2.51 kr1.24 kr
To pay when warrants are issued132,000 kr62,750 kr31,000 kr
To pay when shares are issued500,000 kr750,000 kr1,000,000 kr

The message is clear here: you can either pay a little more today and significantly less later, or less today more later.

However, this is not the only trade-off you have to make. There is also a difference in how much money you make. Here are three tables that show you, for each of the three different strike prices, what an exit at 30 kr per share, 60 kr per share or 200 kr per share gives in profit. These scenarios represent that the price per share increases by 50%, by three and by ten, or two where the company is modestly successful and one where it is very successful. The net profit is the gross profit minus the cost of buying the warrants in the first place. The tax, if you reside in Sweden, will generally be 25%.

Example A: Exit at 30 kr per share (company valuation 75 million kr)

Strike Price Per Share20 kr30 kr40 kr
Profit per share10 kr00
Gross profit250 000 kr00
Net profit118 000 kr-62 750 kr-31 000 kr

Example B: Exit at 60 kr per share (company valuation 150 million)

Strike Price Per Share20 kr30 kr40 kr
Profit per share40 kr30 kr20 kr
Gross profit1,000,000 kr750,000 kr500,000 kr
Net profit868,000 kr687,250 kr469,000 kr

Example C: Exit at 200 kr per share (company valuation 500 million)

Strike Price Per Share20 kr30 kr40 kr
Profit per share180 kr170 kr160 kr
Gross profit4,500,000 kr4,250,000 kr4,000,000 kr
Net profit4,368,000 kr4,187,250 kr3,969,000 kr

What we see here is that in Example A, only the lowest strike prices yields a profit for the warrant holders, whereas in the very successful scenario, Example C, the difference is rather small between the the different strike prices.

Conclusions

What to make of this? On the one hand, if you want to maximize the chance that the warrant program will be profitable, you want a strike that is as low as possible. This also has the benefit that the warrant holder does not have to cough up that much money for the shares. If the warrant holder wants this strike price, but cannot afford it right now, consider lending the money to the warrant holder (legal if the warrant holder does not already own shares). Or simply reduce the number of warrants to the level at which the warrant holder can afford it.

However, if you view the warrant program as a lottery ticket, either the company is hugely successful, or the warrants are not of interest at all, then a higher strike price makes sense, since you have to pay less up front and there is relatively little difference between the different net profits.

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