Anatomy of a convert - why not sell your company in the future for cash now?

r

Perhaps you'd only like to sell part of your company conditional on it having made a success some years in advance.  In which case you'd sell warrants to raise your cash.  A warrant is a call option on corporate shares which you haven't created yet.  If the call is on shares which are already outstanding, then no dilution is happening, and instead the call is just a kind of side bet on your company's stock price between two parties, the winner of which gets some pre-existing shares in your company.  Perhaps the loser already owned those shares anyway before he made his side of the bet?  Perhaps not, and he'll have to purchase those shares in the open market to satisfy his bet.  Derivatives exchanges can create markets in call options.

But the company itself can issue these warrants, on a promise to convert the warrant into new shares in the company.  That way, they're potentially diluting the share base by the size of the warrant issue divided by the number of shares outstanding.  Why's this interesting in the context of corporate finance choices for raising capital?  Well, if you get the cash through issuing a warrant issue, there's a chance (for example if the company's share price closes out the option's expiry period under water - i.e. below the strike price of the warrant ) that nobody will want to execute their right to trade in their warrants for shares in your company.  In other words, you get the cash now for a potential sell of a part of your company which only kicks in if your company share price has risen above the strike price.  This has obvious advantages - you only need to sell that fraction of your company in the happy circumstance that the market rates your company's stock price.  Unfortunately, you get less cash for the warrant since you're only selling a possibility - a right to swap for shares.  That warrant is always going to be worth less than the actual share itself.

Interestingly, this has a knock on effect for analysts, who track, among other things, how much money your company makes in each year, divided by the number of shares outstanding.  This measure, called earnings per share (EPS) explains how much earnings a potential purchase of one of your shares would entitle them to, assuming earnings repeated last year's result (which they rarely do).  If you sold new shares and diluted, then your EPS would drop, making you appear less attractive to potential investors who track this kind of thing.  If you issued warrants, then for the life of the warrants, you still have the original number of shares outstanding so don't take this up front hit every time you need capital.  

Analysts and accounting oversight bodies long since have been on to the potential for abuse in this trick, so you often see 'diluted EPS' reported.  This divides your earnings by the sum of all the outstanding shares, plus any shares which could possibly come into existence through the presence of warrant issues.  Well, not just warrant issues, but any other asset class which has the possibility of creating new shares.  So it is a kind of 'worst case' earnings ratio - the denominator being the largest it could possibly be given outstanding derivative issues.

All the same downsides to dilution we came across here also apply when you chose to dilute your company through derivatives.  One upside is that it gives companies whose stock price is somewhat volatile (for example fairly new companies, perhaps in sectors which exploit a new set of technologies) a comparative advantage, since the more volatile the stock, the higher the fair value of a warrant, all else being equal.

Anyway, what's wrong with just going to your local bank manager and asking him for a loan?  The subject of the next posting.