Warrants and Employee Stock Options

Employee stock options and warrants (both give the holder the right to purchase a security at a set price, usually referred to as the "exercise" or "strike" price) function in about the same way but have two basic structural differences (which explain why warrants tend to go to advisor/investor types while options go to employees).FN1

First, from the issuing company's perspective, warrants behave like a financing (albeit with no initial servicing costs like dividends or interest) whereas stock options behave like an employee incentive. This is because although both warrants and stock options are derivative instruments (the value is not in the thing itself but in its derived value from an actual security (i.e., stock)), the stock ultimately issued for a warrant is newly issued stock - prior to the issuance it did not exist - similar to the way new stock is issued to VCs when they make an investment in a start-up.

The stock issued for an exercised option, by contrast, is derived from the previously existing "stock option pool" (which usually comprises somewhere between 5-20% of the outstanding (i.e., already issued) stock of a company).FN2 Thus as a consequence, the exercise of warrants (like the issuance of preferred stock in a seed or series financing), necessarily dilutes existing shareholders (which is a significant event for the company). The exercise of stock options, by contrast, just consumes some portion of the shares set aside for the stock option pool.

Second, from the holders' perspective, a stock option is less valuable because it is subject to a set of restrictions.FN3 While in most cases a warrant implicates the right to purchase the underlying stock at any point in the future at the holder's reasonable discretion (and in some cases the right to transfer that right), a stock option i) can almost never be transferred, ii) is subject to a vesting period and iii) has a limited exercise period (meaning, the stock option, once fully vested (usually four years down the road), has to be exercised within a few months or a year after vesting).FN4

FN1. This discussion solely addresses the common use of employee stock options and warrants in a start-up context. Stock options and warrants can be manifested in myriad ways - practices outside the U.S. in particular add additional complexity.

FN2. If you get fancy, you can argue that if a company does not presume the existence of a employee stock option pool, the relevant distinction between warrants and employee stock options gets exceedingly small.

FN3. Usually. While employee stock options are highly standardized, the terms of warrants are highly customizable.

FN4. The tax implications of warrants and employee stock options depend on the circumstances. As a general matter, warrants are a taxable event upon issuance but options are not, provided, however, that the warrants were issued as part of a financing while the stock options were issued in exchange for future services. If the warrant is compensatory, taxability is deferred under section 83 until exercise.