Comprehensive Overview of Small-Cap Financing Structures[1]

By Adam J. Epstein

For both new and experienced small-cap officers and directors, the menu of potential financing structures can be somewhat intimidating.  The purpose of this article is to explain the most common types of small-cap equity and equity-linked financings, and the high-level pros and cons of each.

 

Restricted common stock.   This type of financing – sometimes broadly characterized as a PIPE (Private Investment in Public Equity) – involves the sale of authorized, newly issued shares of unregistered common stock to accredited investors subsequent to a privately negotiated, confidential transaction.  It is referred to as “restricted” common stock, because it is ineligible for resale on an exchange until it’s either registered or all the conditions for resale under Rule 144 are satisfied.

  • Pros:
    • Speed to market – because restricted common stock is sold prior to undertaking the registration process with the Securities and Exchange Commission (SEC), companies can transact a financing in as little as several weeks. Consequently, companies can opportunistically take advantage of strength in the market or other events.
    • Lower transactional expenses – the sale of restricted common stock is arguably the least complex form of financing, so it also typically results in lower transactional expense (especially if the restricted stock doesn’t have registration rights).
    • Simplicity – from a balance sheet perspective, as well as from a “Street” perspective, common stock is easily understood.
  • Cons:
    • Pricing – because investors are purchasing stock that is ineligible for immediate or even near-term resale, unregistered common stock is regularly issued at a meaningful discount to the closing bid price or the volume-weighted average price[2] (VWAP). Discounts of 20-plus percent, for example, are not uncommon.
    • Registration restrictions and penalties – companies need to work closely with experienced counsel to ensure that the company is not attempting to register more shares than are permitted by applicable exchange rules and securities regulations. Companies also need to be able to satisfy the negotiated registration timetable, if any, since penalties for breaching those terms can be costly.
    • Hedging – because investors are purchasing stock that is ineligible for immediate or even near-term resale, investors in the transaction, where practicable, might sell the same or substantially similar number of shares acquired in the financing short[3] after the financing is announced in order to attempt to lock-in the negotiated discount. If effectuated, this can negatively impact the stock price.  Moreover, since this practice is widely known and expected, even investors that didn’t participate in the restricted common stock financing might seek to sell the stock short, or simply sell their stock to either take advantage of the likely fall in the stock price, or avoid the same.
    • Offering size limitation – Nasdaq and NYSE have rules which require that, among other things, shareholder approval is required prior to closing any privately negotiated offerings where the company seeks to sell a certain percentage (typically 20 percent) of the company’s issued and outstanding stock at a discount to the closing bid price.

Registered common stock (Registered Direct).   A registered direct offering (RD) involves the sale of authorized, newly issued shares of registered common stock subsequent to a privately negotiated, confidential transaction.  The primary difference between a RD and a restricted common stock structure is the timing of the registration of the stock; that is, in a restricted common stock financing the registration statement is filed after the deal is transacted, while in a RD the stock has already been previously registered. 

 

  • Pros:
    • Stealth – because RD’s are privately and confidentially negotiated, the company needn’t telegraph its intentions to the marketplace, subsequent to its registration statement being filed and declared effective.
    • Speed to market – once the company has an effective registration statement it can undertake “shelf takedowns” quickly, sometimes in a matter of days from start to finish.[4] Confidentiality in the RD process typically leads to more focused deal marketing, and avoids extended roadshows.
    • Pricing – because RD’s involve the sale of registered stock, the discounts are typically smaller than if restricted common stock were sold (i.e., the investors don’t have to absorb registration risk). Moreover, RD’s can often be priced more attractively than follow-on offerings, because subsequent to the shelf being filed and declared effective the deal is marketed privately (i.e., avoids the “double discount”[5] phenomenon which sometimes occurs with follow-on offerings).
    • Simplicity – from a balance sheet perspective as well as from a “Street” perspective, common stock is easily understood.
  • Cons:
    • Time/registration risk – though a company with an effective registration statement can undertake a RD quickly, a company contemplating a RD that doesn’t yet have an effective registration statement is subject to the vagaries of the SEC declaring the registration statement effective once drafted and filed. Accordingly, companies that need capital quickly shouldn’t consider a RD structure (except WKSIs[6]).
    • Offering size – Nasdaq and NYSE have rules which require that, among other things, shareholder approval is required prior to closing any privately negotiated offerings where the company seeks to sell a certain percentage (typically 20 percent) of the company’s issued and outstanding stock at a discount to the closing bid price.
    • Shelf optics – even though the actual shelf takedown is confidentially transacted, filing a shelf in the first place is a conspicuously public event. Depending on the size of the shelf filed, and the financial and operational strength of the company, the stock price can decrease in the immediate wake of a shelf filing, and the risk of the same should be contemplated in the anticipated cost of capital analysis. 

Registered common stock (Confidentially Marketed Public Offering).   A confidentially marketed public offering (CMPO) is very similar to a RD in that it involves the sale of authorized, newly issued shares of registered common stock subsequent to predominantly confidential, private negotiations.  The primary difference between a CMPO and a RD is that with a CMPO after the market closes on the night of pricing the offering, the company files a prospectus supplement and issues a press release to announce an overnight underwritten public offering.  Accordingly, it’s a hybrid RD and follow-on offering, which evolved principally to address the rules enacted by NYSE and Nasdaq to stem the tide of privately negotiated, discounted transactions that sell material percentages (i.e., typically 20 percent or more) of companies without prior shareholder approval.  Because the offering technically becomes a public offering when it is announced the day before pricing, it circumvents the shareholder approval mechanism (i.e., it’s no longer privately negotiated), and permits companies to sell more than 20 percent of the issued and outstanding shares without prior shareholder approval. 

 

  • Pros:
    • Stealth – because CMPOs are privately and confidentially negotiated the company needn’t telegraph its intentions to the marketplace, subsequent to its registration statement being filed and declared effective. The stealth of a CMPO isn’t materially affected by turning it into a public offering, because notice is given after the market closes one night, and before it opens the next morning.
    • Speed to market – once the company has an effective registration statement it can undertake a CMPO quickly, sometimes in a matter of days from start to finish. Confidentiality in the CMPO process typically leads to more focused deal marketing, and avoids extended roadshows.
    • Pricing – because CMPOs involve the sale of registered stock, the discounts are typically smaller than if restricted common stock were sold (i.e., the investors don’t have to absorb registration risk). Moreover, CMPOs can often be priced more attractively than follow-on offerings, because subsequent to the shelf being filed and declared effective the deal is mostly marketed privately (i.e., avoids the “double discount” phenomenon which sometimes occurs with follow-on offerings).
    • Greater flexibility on offering size – NYSE and Nasdaq have rules which require that, among other things, shareholder approval is required prior to any privately negotiated offerings where the company seeks to sell a certain percentage (typically 20 percent) of the company’s issued and outstanding stock at a discount to the closing bid price. Since CMPOs are publicly announced prior to being transacted, no such shareholder approval is required.
    • Underwritten – CMPOs are fully underwritten, which means that once the investment banks present the terms of the financing to the company on the night of pricing and the terms are accepted, the company is at very low risk of not getting the funds.
    • Simplicity – from a balance sheet perspective as well as from a “Street” perspective, common stock is easily understood.
  • Cons:
    • Time/registration risk – though a company with an effective registration statement can undertake a CMPO quickly, a company contemplating a CMPO that doesn’t yet have an effective registration statement is subject to the vagaries of the SEC declaring the registration statement effective once drafted and filed. Accordingly, companies that need capital quickly shouldn’t consider a CMPO structure (except WKSIs).
    • Shelf optics – even though the actual shelf takedown is confidentially transacted, filing a shelf in the first place is a conspicuously public event. Depending on the size of the shelf filed, and the financial and operational strength of the company, the stock price can decrease in the immediate wake of a shelf filing, and the risk of the same should be contemplated in the anticipated cost of capital analysis.

Registered common stock (Fully Marketed Follow-on Offering).  A follow-on offering is functionally the same as an IPO, except the company’s stock is already publicly traded.  It involves the public sale of authorized, newly issued shares of registered common stock.

 

  • Pros:
    • Ability to market/showcase company’s strengths – because follow-on offerings are announced publicly first, there is an opportunity to communicate the company’s story and strategy to a broad audience of new prospective investors.
    • Greater flexibility on offering size – Nasdaq and NYSE have rules which require that, among other things, shareholder approval is required prior to any privately negotiated offerings where the company seeks to sell a certain percentage (typically 20 percent) of the company’s issued and outstanding stock at a discount to the closing bid price. Since follow-on offerings are publicly announced prior to being transacted, no such shareholder approval is required.
    • Equity research – though investment banking and equity research are always independent functions, most investment banks wouldn’t consider underwriting a follow-on offering unless their equity research analyst was intent on “covering” the stock. Accordingly, companies that transact follow-on offerings often are able to add to their existing equity research base, and leverage new institutional sales forces.
    • Underwritten – follow-on offerings are fully underwritten, which means that once the investment banks present the terms of the financing to the company on the night of pricing and the terms are accepted, the company is at very low risk of not getting the funds.
    • Simplicity – from a balance sheet perspective as well as from a “Street” perspective, common stock is easily understood.
  • Cons:
    • Market risk (“double discount”) ­­– because follow-on offerings are publicly announced first, and then transacted thereafter, there is material risk that the stock price will drop when the financing is announced due to the impending dilution. After the initial announcement, the financing is often priced at a discount to wherever the stock stabilizes post announcement.  Accordingly, companies can, in some sense, be subject to a “double discount” when undertaking a follow-on offering.
    • Time and focus – selecting and negotiating an underwriting syndicate can take appreciable time. Moreover, during the marketing roadshow of a follow-on offering, management might visit numerous cities (and sometimes travel abroad) for a number of days.  Accordingly, the time (which is in addition to the registration statement being drafted and subsequently declared effective by the SEC), and lost focus on the business can be material.  Follow-ons are not well suited to companies that require capital quickly.

Note: Small-cap officers and directors often struggle with how to differentiate between RDs, CMPOs, and follow-ons.  Since RDs and CMPOs are extremely similar (i.e., the only reason why a company would undertake a CMPO vs. a RD is if it would like to raise more than what exchange rules allow without a shareholder vote), the watershed decision between the three is really whether to do a fully marketed follow-on or not.  While there are, of course, no hard and fast rules in this regard, here are some key considerations for boards to analyze in order to remove some of the subjectivity.  First, the board should go to nasdaq.com, and print out the institutional holdings of four to six publicly traded industry peers, and compare them.  If the peer companies all have appreciably more institutional investors, and more diverse institutional investors then a follow-on could assist the company in enlarging and diversifying its institutional base to be more consistent with the peer group.  To be clear, even a company that currently has 80 percent of its float owned by institutions still could benefit from a follow-on if it seeks to augment its shareholder base to, for example, include mutual funds that are invested in the peer group, but not in the company.  Second, if the company has never transacted a follow-on, and it became publicly listed through an alternative route (i.e. Form 10, reverse merger, etc.), then a follow-on could be considered as a “re-IPO” – formally introducing the company to the “Street” in the same way as an IPO roadshow.  Last, if the company has conspicuously changed its business focus of late and its original institutional base has long since transitioned out of the stock, the board could also weigh a follow-on. 

Registered common stock (At-the-Market Offering).  At-the-Market offerings (ATMs) are unique financings that are becoming more and more common in the small-cap realm.  The most common form of ATMs are public offerings of authorized, newly issued registered common stock.  In ATM offerings, the company sells stock directly into the market at its discretion through a designated agent at then market prices.   More specifically, a company is able to specify timing, minimum price, and volume of all sales under the ATM.  Accordingly, ATMs differ materially from follow-on offerings where a fixed number of shares are sold at one time at a fixed price.

 

  • Pros:
    • Pricing – one of the primary benefits of ATMs is that the shares are sold into the natural trading flow of the market (i.e., not discounted) without having to market or announce each recurring ATM sale. Once the registration statement for the ATM shares is declared effective by the SEC, the company can use the ATM opportunistically when the stock is buoyant or trading a lot of volume with minimal impact on the stock price.
    • Flexibility – since the timing, size, price, and volume of each ATM sale is controlled by the company, it arguably provides the most flexibility of any commonly used small-cap financing structure.
    • Time/distraction – unlike follow-on offerings, no roadshows are required, and limited management time is required for each sale.
    • Cost – ATM distribution costs typically range from one to three percent; accordingly, they are typically cheaper than most follow-on offerings.
  • Cons:
    • Financing size – because the nature of ATMs is to periodically “dribble” registered shares into the market with minimal impact, they are not well-suited to companies that require material amounts of capital in one lump sum or in a short period of time.
    • Variable financing cost – because ATMs are not sold at fixed prices, the price at which stock is sold fluctuates with the market. This can be good when the stock price is buoyant, and less compelling when the stock price is depressed. 
    • Visibility – companies with fluctuating, less predictable burn rate visibility aren’t good candidates for ATMs, because the times they might require capital could be periods where their stock is trading down or less liquid.
    • Time/registration risk – though a company with an effective registration statement can undertake an ATM quickly, a company contemplating an ATM that doesn’t yet have an effective registration statement is subject to the vagaries of the SEC declaring the registration statement effective once drafted and filed. Accordingly, companies – other than WKSIs – that need capital quickly shouldn’t consider an ATM structure.

Registered common stock (Equity Line).   Equity lines are often confused with ATMs, but the two structures are very different.  The main differentiating feature between an equity line and an ATM is that unlike an ATM, where there are no fixed prices and pricing is agreed upon prior to each drawdown, equity lines rely on fixed prices that are put in place when the equity line agreement is first negotiated between the parties.  The most common form of equity line gives the company the unilateral right, subject to negotiated conditions, to compel the investors to buy authorized, newly issued shares of registered common stock at negotiated pricing.  While pricing is often the subject of extensive negotiation and documentation, the general idea is that there is a pricing period which starts when the company “puts” the stock to the investors, and concludes some number of days thereafter (typically anywhere from five to ten – or sometimes more – trading days).  The actual price is typically determined by picking, for example, the lowest VWAP during the pricing period and paying some negotiated discount off that price.[7] 

 

  • Pros:
    • Pricing – while equity line pricing is not as favorable as ATMs, it can be materially less dilutive than other small-cap financing structures.
    • Flexibility – since the company controls when it puts stock to investors, equity lines provide companies with flexibility.
    • Time/distraction – like ATMs, no roadshows are required, and limited management time is required.
    • Cost – the cost of putting an equity line in place is similar to an ATM.
  • Cons:
    • Financing size – equity lines are not well-suited to companies that require material amounts of capital in one lump sum or in a short period of time.
    • Variable financing cost – because equity lines involve fixed pricing off of variable stock prices, the cost of capital fluctuates with the market. This can be good when the stock price is buoyant (and ascending), and less compelling when the stock price is depressed (and descending). 
    • Time/registration risk – though a company with an effective registration statement can undertake an equity line quickly, a company contemplating an equity line that doesn’t yet have an effective registration statement is subject to the vagaries of the SEC declaring the registration statement effective once drafted and filed. Accordingly, companies that need capital quickly shouldn’t consider an equity line (except WKSIs).
    • Optics/overhang – unlike an ATM where investors have no incentive to sell the company’s stock short or sell the stock they just purchased at market price, equity line investors typically make money by selling short the amount of stock which is put to them daily during the pricing period and capturing the spread. Accordingly, the use of an equity line can put downward pressure on the stock price, provide disincentives for third parties to acquire the company’s stock during periods where equity lines are being drawn upon, or, in the worst case scenario, investors might steer clear of the company’s stock until the equity line is cancelled altogether.

Convertible preferred stock.   In the small-cap realm, convertible instruments allow investors to acquire common shares at a negotiated price by converting or exchanging another security.  In the case of convertible preferred stock, investors typically have the choice of retaining preferred stock (along with a dividend paid in either cash, common stock, or more convertible preferred, and liquidation priority), or converting the preferred into common stock.  Typically, the common stock underlying the convertible preferred is restricted at the time of issuance, but has registration rights.  Like a restricted common stock offering, this structure is typically private negotiated.

 

  • Pros:
    • Balance sheet – if structured properly, convertible preferred stock can reside on the balance sheet as equity.
    • Pricing – unlike restricted common stock, convertible preferred stock typically has less discounted pricing, and might even convert at market (when issued) or at a premium to market (when issued).[8]
    • Structure – being able to structure the terms of a convertible preferred instrument to complement the company’s needs and situation can be a benefit, if artfully negotiated.
  • Cons:
    • Structure – though structure can be a positive in some circumstances, it can certainly also impose restraints on operating the business in the form of, among other things, ongoing covenants and dividend payments. Moreover, the optics of a structured instrument can deter otherwise interested prospective investors.
    • Process – a company must be authorized to issue preferred stock, and also likely needs to file a certificate of designation for the preferred stock with the secretary of state in the state of incorporation. If the company is not authorized to issue preferred stock, it would likely require shareholder approval to amend the company’s articles of incorporation.  Also, the payment of dividends is often regulated by corporate laws in the state of incorporation, so management and counsel need to be well-versed in the same.
    • Accounting – convertible instruments typically contain embedded derivatives which require special accounting treatment. Officers and directors need to make sure that the company’s auditors are experienced with the same, and that everyone understands how much any additional accounting will cost.
    • Offering size – Nasdaq and NYSE have rules which require that, among other things, shareholder approval is required prior to any privately negotiated offerings where the company seeks to sell a certain percentage (typically 20 percent) of the company’s issued and outstanding stock at a discount to the closing bid price.

Note:  There are many small-cap boards that have thought they were raising equity by transacting a convertible preferred financing only to have federal regulators later reclassify it as debt on the company’s balance sheet.  Simply put, over the course of time many so-called convertible preferred instruments started looking more and more like debt when you read the provisions closely; e.g., mandatory redemption features after a specific time.  Accordingly, the Financial Accounting Standards Board and SEC promulgated rules which effectively set forth that if convertible preferred instruments look more like debt than equity, then they will be considered such, irrespective of what companies/investors call them. 

Convertible note.   Like a convertible preferred security, a convertible note allows investors to acquire common shares at a negotiated price by converting or exchanging the note.  However, unlike a convertible preferred, a convertible note holder is a creditor of the company.  Accordingly, the note holder can retain the debt instrument to term (along with interest paid in either cash, common stock, or more convertible notes, and either a secured or unsecured position), or convert the note into common stock.  Typically, the common stock underlying the convertible note is restricted at the time of issuance, but has registration rights.  Like a restricted common stock offering, this structure is typically privately negotiated.

 

  • Pros:
    • Pricing – unlike restricted common stock, convertible notes typically have less discounted pricing, and might even convert at market (when issued) or at a premium to market (when issued).
    • Structure – being able to structure the terms of a convertible note to complement the company’s needs and situation can be a benefit if artfully negotiated.
  • Cons:
    • Balance sheet – since a convertible note is classified as debt on the balance sheet unless/until converted, it may negatively impact debt to equity ratios.
    • Structure – though structure can be a positive in some circumstances, it can certainly also impose restraints on operating the business in the form of, among other things, ongoing covenants and interest payments. Moreover, the optics of a structured instrument can deter otherwise interested prospective investors.
    • Process – since convertible note holders are creditors, notes can either be senior or subordinate to existing debt, and inter creditor negotiations, if necessary, can be contentious, complex, and expensive to document. Moreover, to the extent that a note is secured by corporate collateral, there can be expense and delays associated with valuation and securitization.
    • Accounting – convertible instruments typically contain embedded derivatives which require special accounting treatment. Officers and directors need to make sure that the company’s auditors are experienced with the same, and that everyone understands how much any additional accounting will cost.
    • Offering size – Nasdaq and NYSE have rules which require that, among other things, shareholder approval is required prior to any privately negotiated offerings where the company seeks to sell a certain percentage (typically 20 percent) of the company’s issued and outstanding stock at a discount to the closing bid price.

Note:  Because there is no formal template for negotiating and transacting convertible notes, there are limitless combinations of provisions which can appear in a given instrument. It’s important for management and the board to conceptually understand that most of the commonly negotiated convertible note provisions deal with pricing (original issue discounts, fixed and variable price conversion), seniority/collateral (prohibition against future indebtedness), sweeteners (interest make-whole’s), downside protection (full-ratchet, weighted average anti-dilution), liquidity (registration rights, maintaining exchange listings, volume limitations), and risk mitigation (self-liquidating notes, affirmative/negative covenants, buy-ins).  Thinking about these provisions conceptually, enables officers and directors to avoid the most common mistake in analyzing myriad terms of a convertible note – failing to understand what the investors are trying to achieve with the various provisions.   It also saves precious time and money if officers and directors review the most recent convertible notes transacted by companies in similar industries with substantially similar capital markets profiles (with particular emphasis on which investors were involved).  Since institutional investors tend to use similar term sheets repeatedly, and since similar companies often are offered similar terms, it’s a great way for the company to know what’s likely to be coming their way.

Warrants.   Warrants aren’t a financing structure per se, rather they are financing sweeteners that are extremely common in small-cap finance.  A warrant is in essence a call option; that is, a right granted by the company to an investor to purchase a certain number of authorized, newly issued shares of restricted or registered common stock at a particular price for a negotiated period.  Perhaps unlike any other element of small-cap corporate finance, warrants evoke a binary response – companies loathe them, and investors love them.  Investors get them, because they can.  Companies issue them, because they often have no choice. 

  • Investors like warrants for two principal reasons: (i) they are free[9] opportunities to positively augment their investment returns with little or no corresponding downside risk; and (ii) depending upon a particular funds’ accounting and valuation methodology, warrants can result in immediate gains to the funds’ income statement.[10]
  • Companies, on the other hand, detest issuing warrants, because: (i) they can create an overhang on the stock that dissuades new investors or makes subsequent fund raisings more challenging; (ii) they require expensive, recurring derivative accounting analysis; (iii) they represent more prospective dilution; and (iv) they can negatively impact GAAP results.

Footnotes

[1] This article is based upon a similar chapter in my book, The Perfect Corporate Board: A Handbook for Mastering the Unique Challenges of Small-Cap Companies (McGraw Hill, 2012). 

[2] There are two fundamental measures that can be used to price a financing: (1) the final price the stock traded at before the exchange it’s traded upon closes for the day (also known as the “closing bid price”); or (2) the volume weighted average price (VWAP), which is a calculation – typically taken from Bloomberg – that depicts the average price during the entire trading day, when the volume of stock associated with each individual trade during the day is taken into account.  VWAP is often times more indicative of the actual price on a given day, since the closing bid price is only one trade, and is also more prone to manipulation.

[3] Investors are either “long” stock – where they hope to sell at a higher price than which they bought stock – or they are “short” stock – where they hope the stock decreases in value.  In a short sale, an investor borrows stock from a shareholder (who charges a borrowing fee), and sells the stock.  For example, an investor could borrow 100 shares, and sell them for $10 dollars each (or a total of $1,000 dollars).  If the stock decreases to $5 dollars, it would cost $500 dollars for the investor to purchase the 100 shares, and deliver back the 100 shares they borrowed (“covering” the short sale).  In this example, the investor would profit from the $500 dollar differential when the short sale is covered (less any costs they incurred for borrowing the stock).

[4] An effective Form S-3 Registration Statement is often referred to as a “shelf.”  That is, companies that have effective S-3’s essentially have registered stock they can sell to investors opportunistically; i.e., the stock is simply sitting on a “shelf” waiting to be sold to investors in a financing.

[5] In a public offering, an issuer files a registration statement, and after the registration statement is declared effective, the company holds informational meetings with investors – the “roadshow” – that are non-confidential, public meetings.  The simple act of filing a registration statement can signal to investors that dilution in coming, and stock prices can fall as a result.  After the registration statement is effective, and the roadshow begins, investors are once again on notice that dilution is imminent.  Each one of those actions – filing the registration statement, and commencing the road show – are opportunities for the stock to decrease; hence the notion of a “double discount.”  In a registered direct financing, for example, there is no public roadshow, so the market isn’t on notice that a financing is imminent (i.e., no double discount possibility).

[6] A WKSI – or well-known seasoned issuer – meets a number of requirements, including being larger than ~ $700m market capitalization.  A WKSI Form S-3 registration statement is considered effective upon filing.

[7] For example, a company might have a contractual right to have the equity line investor purchase 100,000 shares.  An equity line agreement might state that the purchase price will be at a ten percent discount to the lowest VWAP during the ensuing 10 days of trading, subsequent to the company notifying the investor.  The stock price could climb during the pricing period or decrease, but the price paid for the 100,000 shares by the equity line investor will be equal to 90 percent of the lowest VWAP during the period.

[8] The reason why convertible pricing is typically less discounted than restricted common stock is two-fold: (i) even though the common stock underlying the convertible instrument is restricted at issuance, investors are offered compensation to wait for registration and profitable conversion in the form of a dividend and liquidation priority; and (ii) many institutional investors account for convertible instruments at “par” such that their investment returns are less affected by price volatility in the underlying common stock.

[9] There are occasions where investors pay for warrants, but quite often they are simply issued in small-cap financings as sweeteners – gratis.  When it comes to exercising warrants, some require holders to pay cash for the exercise price, and some warrants permit cashless exercise.

[10] Small-cap officers and directors often don’t completely appreciate fund management accounting drivers which can make warrants attractive to hedge funds.  There are some hedge funds, to be clear, that ascribe no value whatsoever to warrants unless or until the warrants are exercised, or the actual warrants are sold to a third party.  Hedge funds that do value warrants when issued tend to mark them at some predetermined percentage of the Black-Scholes value; the three main inputs to determine Black-Scholes valuation are time (the length of the warrant remaining), intrinsic value (market price for the stock less the strike price of the warrant), and volatility.  Given the high volatility quotient for many small-cap stocks, and the five to seven-year duration of many warrants, it suffices to say that even if the warrants lack intrinsic value, they can still add incremental profit depending upon how aggressively or conservatively a given fund accounts for them.  It’s perhaps worth noting that there are some hedge funds that value warrants at their full Black-Scholes valuation upon receipt, irrespective of whether they can be exercised or not.  Reasonable people will differ on the propriety of the same, but it’s important, nevertheless, for officers and directors to understand what’s driving the motivations of funds that seek material warrant “coverage.”  It’s especially important to be mindful of these fund accounting treatments when companies attempt to offer, for example, inducements for investors to exercise their warrants.  Officers and directors often can’t understand why investors wouldn’t want to exercise in-the-money warrants (even if the strike price is lowered as an inducement), whereas hedge funds actually might be taking a hit to their profit, because they are going to lose the volatility and time values when the warrants are exercised.