A cashless warrant exercise decision boils down to a need for cash vs. mitigating the impact of dilution.

Most people don’t waste their time picking up pennies anymore if they see one lying on the ground. The cash isn’t worth the hassle. My daughter still does, but it has to be lying heads up, or she’ll pick it up and drop it until it’s lying heads up and then go in for the kill.

When I was trading a Nasdaq desk on Wall Street, I saw traders pass on money that was figuratively lying at their feet.

I witnessed in shock the head trader on the desk ask a trader, who to his credit was a little busy, if he would like to have a position put into his account that was a 100% guaranteed profit. He could have also made more money on the hedged position when taking it off.

It was free money, and he politely said, “No thanks.” For whatever reason, he had done the calculation in his mind, and it wasn’t worth it to him.

It may be surprising, but there are legitimate reasons a company would pass on cash and do a cashless warrant exercise. To understand why, let’s first define a cashless exercise. And then run out the reasons why a company would want to do one, or not.

Definition: Cashless Warrant Exercise

A cashless warrant exercise is when a company, which would usually accept a warrant plus some amount of cash, the exercise price, in exchange for stock, instead accepts the warrant and no cash, in return for a smaller amount of stock.

The end result for the warrant holder is the same. And, it is beneficial to the warrant holder in that they do not have to put up additional cash to exercise. This can be very helpful if you hold a large number of warrants.

The terms of the cashless warrant exercise should be spelled out by the company in the original filing which detailed the exercise price of the warrants. One example of how a cashless exercise may look, as filed by Phunware, is:

…each holder would pay the exercise price by surrendering the warrants for that number of shares of common stock equal to the quotient obtained by dividing (x) the product of the number of shares of common stock underlying the warrants, multiplied by the difference between the exercise price of the warrants and the “fair market value” (defined below) by (y) the fair market value. The “fair market value” shall mean the average reported last sale price of the common stock for the 10 trading days ending on the third trading day prior to the date on which the notice of redemption is sent to the holders of warrants. 

Phunware SEC Filing

The resulting equation is X = Y(a-b) / a where:

• X = the number of common shares you’ll receive when exercising
• Y = the number of warrants you are exercising
• a = “fair market value”, or the average closing price of the common for 10 days, ending on the third trading day prior to the date on which the notice of redemption is sent to the holders. The notice of redemption will have this price in it, and you can always verify the price with your broker.
• b = the per share exercise price

You can find an example of this equation in this SEC filing, and if you’re a glutton for punishment this is a detailed warrant agreement.

Considerations for a Cashless Warrant Exercise

There are two questions a company must answer when deciding whether to do a cashless exercise:

1. What are the cash needs of the company currently?
2. How much will the exercise of warrants dilute the common stock, and how would a cashless exercise impact dilution?

Does the company need cash?

The first question is paramount and may negate the need for the second question altogether.

Does the company need cash? In that category we can put growth companies, small companies, young companies, companies in debt, etc. Most companies, not all, but most, that issue warrants fit into this category. They generally need cash and will turn it away from very few sources.

Phunware (PHUN) is a perfect example. They’re burning through investment dollars in a race to stand up their tokenized advertising platform before another company does the same. Or, before Facebook (FB), or Google (GOOGL), or Amazon (AMZN) does it first and eats their lunch.

They need cash. If they do call their warrants, I believe this question alone will dictate whether they do a cashless exercise. They shouldn’t.

On the other hand some companies, like those doing stock buybacks, (shhhh, come closer, Chuck or Bernie may be listening) would prefer a cashless exercise because they don’t need the cash. If they’re returning cash to shareholders already, they would almost certainly do a cashless exercise.

A company flush with cash and sending it back to shareholders, is a perfect candidate for a cashless redemption.

The second question around dilution is impacted by where the common stock is trading, or the fair value.

What is the impact of dilution?

First, a cashless exercise provides less dilution to the common stock than a normal exercise. That’s not a question, but a statement. So if a company’s goal is to distribute cash and dilute the current shareholders as little as possible, boom, cashless exercise, he shoots, he scores.

Second, you know those optical illusions when you’re shown two lines of different lengths then the picture is changed slightly and the lines are actually the same length?

Cashless exercises are kinda like the opposite of this really cheesy video. The line may look the same but, depending on the price of the underlying common stock, it can be really different.

Let’s look at a couple of examples.

Example Cashless Warrant Exercise

Back to our equation: X = Y(a-b) / a.

We’ll use two different prices for a. Let’s see what dilution looks like if the “fair value” price is $100 vs. $15. We’ll also assume we have 1,000 warrants. And, that the warrant is exercisable for one share of common at an exercise price of $11.50.

At a price of $100 our equation would look like this:

X = 1,000(100-11.50) / 100 or X = 885. So with the stock trading at an average price of $100 prior to redemption, we would receive 885 shares of common in a cashless exercise. Instead of 1,000 additional shares of common there are only 885. Dilution is 11.5% less than what it would have been with a normal exercise.

But let’s look at what happens to dilution if the “fair value” price of the common is $15 when the warrants are called.

X = 1,000(15-11.50) / 15 or X = 233.33. The value a shareholder receives for her warrants is the same in relationship to the common. In this case our warrants were worth $3,500 at parity and prior to exercise. (Meaning the warrants would have been trading at $3.50 at parity, so 1,000 warrant shares would be worth $3,500. When exercised, the value would remain the same, we would just have common stock now worth $3,500.)

BUT, look what happens to dilution. When we exercise 1,000 warrants in a cashless redemption with the stock price at $15. We only receive 233 shares, not 885. Dilution in a cashless redemption at $15 is reduced by 77% from what it would have been exercising the warrants the normal way.

A company that wants to minimize dilution of current shareholders, especially if those shareholders are founders and managers of the company, may very well be tempted to do a cashless exercise if the price is right.

Management’s Decision

Given theses numbers, what would management do if the stock were trading around $100, with an $11.50 strike on the warrants, assuming a warrant redemption?

They would answer our original two questions. Do they need cash? And, what is the impact of dilution?

If they need cash, dilution is a secondary issue. Who cares what the dilution is if you’re going to run out of cash.

But, even if dilution comes into the picture, a cashless exercise in this scenario doesn’t really give them much in the way of reducing dilution.

This makes a cashless exercise much less likely than a normal way exercise.

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