This article is written by Soham Bipin Devlekar, pursuing Diploma in US Contract Drafting and Paralegal Studies from LawSikho. The article has been edited by Smriti Katiyar (Associate, LawSikho).
In the US, usually, a common stock warrant is issued for raising capital in a company. Nonetheless, any business needs to gather funds or raise capital to function properly. The common stock warrant is quite confusing at times and also crucial for people to know what new opportunities of investing are there in the market. If this type of warrant is not properly used between two companies, it will be vulnerable to serious threats. Therefore, drafting a legal document such as a common stock purchase warrant before actually purchasing the warrant is highly advisable and helpful in the long run. Drafting a Common Stock Purchase Warrant between two companies means a purchase agreement of stock warrants and one company buying the stocks of the other to raise capital. There are legal issues that will arise if the clauses are not drafted accurately, compliance is not performed well, and if the parties to the contract are not satisfied. We will understand what a stock warrant is, the difference between stock options and stock warrants, and most importantly in-depth analysis of the two parties in the common stock purchase warrant agreement and delve into all the nitty-gritty of this agreement in this article.
The basic concept of a Common Stock Purchase Warrant as per US laws
What is a stock warrant?
A stock warrant is a contractual agreement between two parties, where one party buys the shares of the other at a set price within a specific period of time. The price is known as the ‘strike price’ while the date is known as the ‘expiration date’.
A stock warrant gives holders the option to buy company stock at a fixed price, the exercise price, until the expiration date and receive newly issued stock from the company.
A stock option is a contract between two parties, the issuer and the holder, and gives the stockholder the right to buy or sell stocks at a certain price and on a certain date. When an investor exercises a warrant, they purchase the stock and are a source of capital for the company. The warrant is not the actual ownership of the stock of the company’s shares but a purchase done at a particular price in the future. The US stock warrants have a feature for the holder to exercise the warrant at any time to buy or sell but it shall be before the date of expiration.
Types of stock warrant
There are two kinds of warrant: Call Warrant and Put Warrant
- A call warrant purports to give an investor the right to purchase a specified number of shares at a specified price in the future from a company.
- Put warrants allow the holder to sell back a specified number of shares to the issuing company at a specific price in the future.
In the US, stock warrants are relatively uncommon, though they are becoming more popular among investors who invest in special acquisition companies (SPACs).
Let’s understand common stock
A security that represents ownership in a business incorporated under the laws of a US state, such as Texas, is known as common stock. In terms of ownership structure, common stockholders are at the bottom of the priority ladder. Only when secured lenders, debtholders, other creditors, and preferred shareholders have been paid in full, the common shareholders have rights to a company’s assets in the case of liquidation.
Hence, a common stock purchase warrant is a combination of an agreement to issue the purchase of shares of a company that will be legally enforceable and valid for both parties.
Why do companies release stock warrants?
An important characteristic of a stock warrant is that the company can issue new shares for the new investors at a low price, this becomes extremely beneficial for both the parties and a potential funding source if the company is on the verge of bankruptcy or a merger. For example, an investor would purchase 25$ worth of warrants and then buy a 250$ stock share.
Key differences of stock options and stock warrant
A stock warrant differs from the stock option mainly in two aspects:
- A company issues its own warrants,
- The company issues new shares for the transactions.
A company may issue a stock warrant if they want to raise additional capital from a stock offering. Shares are sold at $100 per share but warrants are offered at just $10, so more investors will exercise a warrant. These are a source of future capital. Stock options on the other hand are listed on exchanges. When stock options are exchanged, the company itself doesn’t make any money from those transactions. Also, stock warrants can last up to fifteen years, while stock options usually go for a couple of months to a couple of years at best.
Common Stock Purchase Warrant Agreement as per US Laws
As per US laws and in this agreement, the SEC (Securities Exchange Commission) plays an intrinsic role in maintaining the SEC reports of a Company and this agreement will be governed by Securities Act of 1933, as amended or the Securities Exchange Act of 1934, as amended. Every state in the US has a different approach to the Securities Act hence it depends on the state laws of the US as every state has a constitution of its own.
Drafting a Common Stock Purchase Warrant between two companies based in Texas
This agreement will comprise companies who will come to an agreement where one company will buy the stock warrants of the other to raise capital, collaboration, partnerships, etc to purchase warrants in Texas. (Although, these types of agreements drafted in the US does not differ that much from state to state as these agreements have generic clauses and the commercial intent is the same compared to all states).
Important clauses for such warrants
Important clauses pertaining to Common Stock Purchase Warrant Agreement is provided below:
Mostly, all US-style agreements have the same format of drafting where clauses will be divided by sections of “Articles”. Each article has its own part to perform pursuant to the Agreement.
- Parties to the Agreement: This is the basic yet important clause in any agreement where one should mention and know what parties are transacting through this agreement. For a common stock purchase warrant, the parties can be mentioned as the company and the investor, or the company and the purchaser.
- Recitals: This clause should not only include the background but also the objectives of the transaction and specific about shares, legal framework related to it.
- Definitions and Interpretations: The terms in the Agreement should be explained in this clause such as “Closing Date” or “Securities Act”.
- Purchase and Sale of Stock Warrant: This clause should include how much stock warrant has been purchased, at what percentage, and at what price including the obligation of an investor to buy those warrants.
- Closing: This clause is crucial in a common stock purchase warrant as it denotes specific time, place, and all the essential details while the stock warrant will come to an end. This clause hence should include all the minute details.
- Conditions to Obligations of Purchaser and Company to Effect of the Closing: This should include all the obligations set forth in the Agreement during the closing of the stock warrant between both the parties.
- Representations and warranties of the Company: The Company shall make representation and warranties to the investor by adding sub-clauses such as subsidiaries, organization, and qualification, filings, consents and approvals, no conflicts, and capitalization. Here, SEC reports sub-clause is a major aspect as it deals with all the legality of the Agreement and complies with the Securities act.
- Representation and warranties of the purchaser/investor: It is a repetitive clause where the parties’ interest is safeguarded.
- Indemnification: It deals with both parties indemnifying each other against any losses, damages, or expenses also with the indemnifying procedure, time limit, and the scenarios mentioned in detail.
- Governing Law and Jurisdiction: The governing law will be applicable to the Texas State under the laws of Texas and agreement shall be executed with respect to the state.
Advantages and disadvantages of a common stock purchase warrant agreement
Some of the advantages are:
- It has great profit potential to both the parties as the investor will invest at a very low price in warrants and the company will issue warrant shares to benefit the company.
- Great for small investors to the agreement who have low buying power and the agreement will be a means to negotiate all the terms.
- The common stock warrant will not expire early as compared to the stock options purchase otherwise mentioned earlier. This will give more time frame and it’s a win-win situation for both parties.
- This type of agreement helps to purchase the warrants and works as proof if any legal issue arises in the future. It also helps in eliminating the mediator where companies are directly making an agreement with the investors to purchase common stock warrants.
Some disadvantages are:
- If the common stock purchase warrant agreement is not drafted well that will hamper the investor’s credibility.
- Investors have risks as common stock purchase warrants are high risk and high rewards therefore while entering into an agreement one must weigh all the pros and cons.
Key concerns to be kept in mind when drafting a Common Stock Purchase Warrant between two companies based in Texas
While drafting a common stock one must not use a template of a common stock purchase warrant.
The clauses must be drafted and customized for the benefit of the parties.
It should comply with the regulations of the Securities Act and all the laws relating to Texas.
The governing law provision should be checked twice as it is an important clause.
The SEC reports must be compiled and prepared for the efficiency of this Agreement.
The due diligence must be carried out to avoid further repercussions.
Common Stock Purchase Warrant drafted should be according to both the parties’ requirements and benefits.
While drafting a common stock purchase warrant agreement, one should note that the agreement should be made with both parties agreeing and having consensus and also required information of the stock warrant should be specified, it is advisable that this agreement be drafted and consulted by the respective lawyers to avoid any future misunderstanding leading to litigation as a dispute over unforeseen costs or other issues could cause a disagreement between the purchaser and seller. Without a stock purchase agreement, there is no method of dispute resolution explained. This could result in court costs. If an agreement is in place, the parties at least have guidelines on how to handle the disagreement.
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