To raise funds, a company may issue stocks, which represent all or part of the ownership of the company. Additionally, the company may also issue warrants. The company does not earn any money from issuing warrants, but it will earn money when the warrants are converted into stocks.
A warrant gives the holder the ability, but not the obligation, to buy a company's stock at a certain exercise price. A warrant's exercise price at issuance is usually higher than the actual price of the stock. As such it makes no sense to exercise the warrant immediately because the holder can buy the stock at a cheaper price. If the stock price goes up, the warrant holder may benefit from exercising the warrant to buy the stock below market price.
Effects on Stock Dilution
When a warrant holder exercises a warrant, he pays the company to convert the warrant into stock. The warrant holders buy the company stocks at the predetermined exercise price and the company earns cash from the conversion. At the end of this process, the number of stocks the company has in the market increases. For example, the company has 10,000 stocks in distribution and 2,000 warrants. If warrant holders convert 1,000 warrants into stocks, the company now has 11,000 stocks in distribution.
Fully Diluted Value
When an analyst calculates the value of a company, he often uses the fully diluted basis. This means that the analyst calculates the value of all the shares of the company that are in the market. Additionally, the analyst also assumes that all the company's warrants and options have been converted into stocks. For example, using the company from the previous example, even if only 1,000 of the company's 2,000 warrants have been exercised, the analyst will base his calculations on the company having 12,000 stocks instead of 11,000 in distribution.
The number of stocks in circulation may have a large impact on the valuation of the company. Investors may determine whether to put their money in a company based on an analysis of figures such as the company's earnings per share. A higher number of stocks leads to lower earnings per share. Dilution also reduces the amount of dividends each stockholder earns. For example, if the company pays out $100,000 and there are 11,000 stocks outstanding, each stockholder would earn $9.09. With 12,000 stocks, each stock would only get $8.33 in dividends.