The current article covers different aspects related to the preferential allotment of stock warrants / share warrants to promoters. The article focuses on the significance of warrant issuance from the perspectives of a retail investor and how she should analyse and interpret issuance of warrants.
Warrants are like stock options where the promoters get a right to acquire new shares from the company at a fixed price by paying 25% of the money upfront. After warrants are allotted to the promoters, then they may approach the company any time within next 18 months and get shares from the company at the predetermined price irrespective of the current market price of the shares of the company.
Over time, during our analysis of the incidences of warrant issuances by companies, we have noticed some key characteristics for preferrential allotment of warrants to promoters. These are:
- Stock warrants are insider trading timed to perfection
- Using stock warrants, the promoters get shares of their company at a cheaper price than the market price. Many times, the promoters book profits by selling these shares at a higher price in the market.
- In the preferrential issuance of warrants, the odds are highly against the company and minority shareholders. The stock warrants are only 25% beneficial to the company whereas they are 75% beneficial to promoters.
In the current article, we would discuss examples illustrating each of these situations. We will also discuss conditions where warrants are allotted to the promoters at a price higher than the prevailing stock price as well as the situations where the bankers force the company to issue preferrential warrants to promoters.
Lets see these aspects of preferrential issuance of warrants to promoters in details.
Stock warrants are insider trading timed to perfection!
The case of warrant allotment by Indo Count Industries Ltd to its promoters in 2013 is a good examples to understand how promoters used the stock warrants to benefit themselves like a person with insider information.
Indo Count Industries Ltd approved the allotment of 28,98,300 stock warrants to promoters in the meeting on September 11, 2013, at a price of ₹17.25 per share (pre-split price, the post-split equivalent price would be 1/5 of it: i.e. ₹3.45 and the number of shares post-split would be 5 times: i.e. 1,44,91,500).
The Shareholders of the Company in their Extra Ordinary General Meeting held on 11-09-2013 accorded their approval for issue and allotment of 28,98300 equity share warrants at ₹ 17.25 each (including premium of ₹ 7.25 each) on preferential basis to promoter group. The Company alloted 28,98,300 equity shares at a premium of ₹ 7.25 each on 20-12-2014 which shall be subject to a lock-in period of 3 years as specified under Regulation 78 of Chapter VII of the SEBI ICDR Regulations, 2009.
The (post-split) share price of the company on September 11, 2013, was in the range of ₹5.44 meaning that the promoters had a gain of ₹2.9 cr [1.44 cr. Share * (5.44-3.45)] on the very day of allotment.
The stock warrants are allotted by companies based on a formula, which is based on the share price levels of past 6 months and are allotted by taking 25% of the value at warrants allotment. The balance 75% of the money is collected when the warrant holder converts them into equity shares.
In the case of Indo Count Industries Ltd, the promoters paid the 25% price of allotment i.e. ₹1.25 cr (1.44 cr. Shares * ₹3.45 * 25%), which the company disclosed in the FY2014 annual report, as share price money pending allotment.
The above information indicates that the promoters paid ₹1.25 cr for something which was giving them a profit of ₹2.9 cr right on the day of allotment.
An investor would notice that stock warrants are like call options where the holder has paid a premium of 25% of the value and would convert the warrants into equity shares by paying balance 75% only at the time of conversion the price of the equity share of the company is higher than the warrant allotment price. Stock warrants are usually convertible within 18 months from the allotment.
An investor would notice that the stock warrants holder (promoter in this case) has got a right to subscribe to the company shares and increase her stake in the company at a predetermined price without worrying about the usual share price increase which happens if the promoters buy shares of their company from the open market. In case the share price does not increase, then the promoter simply lets the warrants expire.
That’s even though the companies say that stock warrants are issued to the promoters in lieu of the capital infusion by them at times when the company needed funds. However, I call stock warrants a legal instrument in the hands of promoters/allottees to speculate on their company share price. And invariably, the persons to bear the cost of such speculation are the minority shareholders.
An investor would see that the promoters infused ₹1.25 cr for allotment of stock warrants in FY2014. Looking at the financials of the company in FY2014: Sales of about ₹1,468 cr, net profit of ₹110 cr, debt of ₹434 cr and interest expense of ₹50 cr, the infusion of ₹1.25 cr by promoters seems insignificant in terms of overall financial position of the company and that too by calling a special extraordinary general meeting.
If it was urgent, then Indo Count Industries Ltd could have collected this much amount by making a single phone call to any of their customers so that they may pay ₹1.25 cr from the outstanding trade receivables of ₹127 cr on March 31, 2013, and ₹167 cr at March 31, 2014. Such collection in the time of urgency would not have been difficult from long-standing customer relationships.
Moreover, even if the company needed funds, the promoters did not infuse the balance 75% of the warrants funds i.e. ₹3.73 cr (1.44 cr. Shares * ₹3.45 * 75%), until December 20, 2014, which is good 15 months post allotment. If the stock warrants were allotted supposedly for the urgent requirement of funds by the company, then the balance 75% funds infusion would have come much sooner. However, even the balance 75% (₹3.73 cr) seems insignificant in terms of overall finance requirement of Indo Count Industries Ltd.
Anyway, the promoters got 1.44 cr. shares (post-split) at December 20, 2014, at an effective price of ₹3.45, which is the original warrant allotment price. The post-split share price of Indo Count Industries Ltd at December 20, 2014, was about ₹60. Therefore, at the time of allotment of equity shares, the promoters had a gain of about ₹56.55 per share (post-split, ₹60 – ₹3.45), amounting to a total gain of ₹81.43 cr (1.44 cr shares * ₹56.55).
Moreover, the conversion of stock warrants allowed the promoters to increase their stake in the company by 3.20%.
The increase in stake in the company for the promoters comes at a very low cost of ₹4.97 cr (1.44 cr shares * warrant allotment price ₹3.45), which otherwise would have cost them about ₹86 cr (1.44 cr share * price at equity conversion date ₹60). This is without considering the almost certain possibility that if the promoters would have bought these additional shares from the open market, then the market would have taken the share price at a much higher level than ₹60.
Further, there is a peculiar observation related to the timing of conversion of stock warrants into equity shares in December 2014. As per our analysis above, we have observed that from FY2014, the performance of the company had started improving a lot and as a result, the company came out of the corporate debt restructuring (CDR) in March 2015, which is just 3 months after the promoters converted their warrants into equity shares.
No wonder, the promoters converted their stock warrants in December 2014, as they know the best out of all the people, about the financial position of the company at any point of time and that the company would be exiting the CDR very soon. As is normally expected with a company showing improving business performance, after the exit from CDR, the share of Indo Count Industries Ltd raced ahead and touched the lifetime high of ₹249.69 on February 8, 2016, valuing the 1.44 cr shares (post-split) converted by promoters from warrants at ₹360 cr. It must be remembered that promoters got these shares by getting the warrant allotment at ₹4.97 cr. (1.44 cr share * ₹3.45 post-split allotment price).
This is an example of someone having her cake and eating it too.
Investors may read our complete analysis of Indo Count Industries Ltd in the following article: Indo Count Industries Limited
While reading about companies issuing warrants to the promoters, an investor would also come across instances where the promoters initially got the shares from the company at a cheaper price using warrants and then sold these shares in the market later at a high price to book the profits. Let us see such a scenario in real life companies.
Promoters get shares via warrants at a cheaper price and then sell them at a higher price in the market
Investors may find such an example while analysing PIX Transmission Ltd, a manufacturer of power transmission belts applicable in industrial, agricultural, lawn & garden and automotive segments.
While analysing PIX Transmissions Ltd, an investor would notice that from March 2012 to December 2017, the shareholding of the promoters has witnessed an increase by about 9% from 51.90% in March 2012 to 60.96% in December 2017.
On the face of it, the decision of promoters to increase their stake in the company looks like a very positive development and shows the confidence that the promoters have in the future of the company. However, while analysing the promoters’ shareholding in the company, we have extended our analysis beyond March 2012 and have analysed all the changes in their shareholding from March 2009 onwards.
The following table reflects the key findings from the analysis of promoters’ shareholding over time:
A) Promoters subscribed to 28,00,000 warrants at a conversion price of ₹30 before FY2009. (We could not get annual reports of the company prior to FY2010; therefore, we are not able to find out the exact year of warrants allotment. In all probability, warrants should have been issued in FY2008). The following section from FY2010 annual report, page: 21, highlights the warrants allotment price and the conversion of 4,15,000 warrants in FY2009 and 11,45,000 warrants in FY2010 i.e. 15,60,000 warrants (4,15,000+11,45,000) were converted into equity shares by FY2010:
B) In FY2011, the remaining 12,40,000 warrants (28,00,000-15,60,000) were converted into equity shares. FY2011 annual report, page 30:
C) An important aspect to note here is that even though the promoters received 28,00,000 additional shares at ₹30 from the company by conversion of warrants during last three financial years (FY2009-11), however, they did not retain all of these shares with them. In fact, the promoters kept on selling part of these shares along the way.
- In FY2010, as per the table above the promoters received 14,50,000 additional shares from the company, however, during the year, their shareholding increased by only 6,25,839 shares indicating that the promoters sold 5,19,161 shares during the year out the new shares received by them from the conversion of the warrants.
- In FY2011, the promoters received 12,40,000 additional shares from the company, however, during the year, their shareholding increased by only 6,85,239 shares indicating that the promoters sold 5,54,761 shares during the year out the new shares received by them from the conversion of the warrants
- During June 2011 quarter, promoters sold additional 3,99,474 shares indicating that during FY2010, FY2011 and Q1-FY2012, the promoters sold about 14,73,396 shares out of the total 28,00,000 shares received by them from the conversion of warrants. Promoters had received these shares at ₹30 from the company.
A look at the share price movement of the company over last 10 years shows that during FY2010 and FY2011, the share price of the company was consistently above ₹75 for the most period and has crossed ₹100 at times.
It seems that the promoters used the opportunity of the share price recovery post 2008 global slowdown to realize the gains, which had accrued to them because of allotment of shares at a price, which was at a discount to the market price.
Therefore, some investors may believe that the decision of promoters to subscribe the warrants is an act of helping the company by putting in their equity in the company. However, we believe that such deals where promoters enter into conditions of infusing part of the money upfront (10% in this case) and hold back remaining (90%) of the money to be infused at a later stage, are most of the times favouring the promoters/warrant subscribers.
As witnessed in this case, the promoters agreed to infuse a total amount of ₹8.4 cr. (28,00,000 * ₹30) in the company as equity. However, they infused only 10% of it (₹0.84 cr.) upfront at the time of allotment of warrants. They paid the remaining amount later when the market price of the shares was higher than the warrant allotment price (₹30). The promoters benefited by selling part of these additional shares received by them by directly selling these shares in the market at a higher price shortly after allotment.
Moreover, an investor would note that the amount of capex done by the company during FY2008-10 was about ₹100 cr. The amount of money given by the promoters up front (₹0.84 cr.) is negligible when compared to the overall fund requirement of the company.
Therefore, the process of getting shares by way of warrant allotment and then sell them in the market at a profit seems like an attempt of the promotes to benefit at the cost of minority shareholders.
You may read the complete analysis of PIX Transmission Ltd in the following article: Analysis: PIX Transmission Ltd
Stock warrants are 25% beneficial to the company and 75% beneficial to promoters!
In case of warrants, the promoters give a part of the money upfront to the company on allotment and then pay balance amount of the money at the time of conversion of the warrants into equity shares. Before 2009, the promoters were required to pay only 10% of the money at allotment and balance 90% at the time of conversion. However, from February 2009, SEBI changed the guidelines and increased the upfront payment to 25%.
Therefore, now we believe that the warrants are 25% beneficial to the company and 75% beneficial to the promoters. Before February 2009, this ratio was 10% beneficial to the company and 90% beneficial to the promoters.
The key reason that led SEBI to increase the upfront payment for warrants was that the promoters used warrants to enrich themselves when the stock markets rose while their loss was limited to only 10% if the markets fell. (Source)
There were complaints that promoters allotted warrants to themselves and select investors at a pre-determined price, but didn’t buy them when the due date came if the prevailing stock prices were lower than the decided price. If the prices were higher, they would convert those warrants and at least make a paper profit, and in some cases encash the gains.
It is to discourage promoters from trading profits. Warrants are seen as an instrument that gives an advantage to promoters above retail investors, who have all other rights equal to company founders.
When the markets melted during 2008 and early 2009, promoters of many companies such as Hindalco Industries, Tata Power, GE Shipping and Pantaloon Retail did not convert those warrants, regulatory filings show.
After similar complaints, in February 2009, the regulator had raised the up-front margin to be paid by warrant subscribers to 25% from 10% since the payment lost was insignificant compared with the losses one would have made if forced to buy.
Common logic says that anyone holding stock warrants would not exercise them to get shares at a price, which is higher than the price at which he/she can get shares from the market.
More so, if the intention of the promoters is to infuse money into the company, then they should simply get all the shares at the current market price and give the entire money to the company upfront so that the company may use it for the purpose for which it needs money.
The entire gimmick of paying 25% at the time of allotment of stock warrants and then keeping the option to pay 75% at the time of exercise, which the promoters would decide based on whether at the date of exercise, the promoters are making money or not, seems like a facade to us.
If the promoters pay 25% now and let the stock warrants expire due to the market price being consistently lower than the exercise price in future, then it effectively means that the promoters did not have the true intention of infusing 100% of the money or that the company did not need 100% of the money.
It might be that the company needed only 25% of the money, which promoters put in by way of stock warrants allotment and the right to get shares in future at a discount is the payoff that promoters would enjoy as a consideration for giving 25% to the company. The company might not have needed the balance 75% at all.
Nevertheless, we believe that if the promoters wish to infuse funds into the company, then the company should straight away issue additional shares to them at prevailing market price and get 100% of the funds upfront rather than letting the promoters speculate at the company’s share price by holding back 75% of the funds as happens in case of stock warrants.
Further Reading: Steps to Assess Management Quality before Buying Stocks
Many times, when the markets crash after the allotment of warrants and the promoters refuse to exercise the warrants and pay the balance money, then the promoters lose the money, which they had paid upfront on the allotment of the warrants. However, in such situations, an investor should not think that the promoters have lost and the company got free money.
An investor should understand that it is the promoter who is incharge of the company. He makes the decisions on behalf of the company. He will not take the loss sitting down. Many times, investors would notice that when promoter lose money on a warrant issuance as the markets had crashed, then they make the company come up with a second warrant issuance, which is usually bigger in size and at a cheaper exercise price. This is primarily to recover their losses in the first warrant allotment.
Let us see the example of ADF Foods Ltd. in which the promoters lost about ₹1 cr to the company in 2009 when the markets crashed after warrant allotment and they could not exercise the warrants. Immediately after the loss in the first warrant issue, the promoters came up with another bigger warrant issue at a much cheaper price where they could recover their losses.
FY2010 annual report of ADF Foods Ltd, page 6:
The Company had allotted 15,00,000 Convertible Warrants of Rs. 70/- each (Rs. 7.00 per warrant paid on allotment) on preferential basis to Promoters/Directors, their friends and relatives on 24 th December 2007. None of the subscribers of the warrants had exercised their option and the same expired on 23 rd June 2009. Rs. 1,05,00,000 received on allotment of warrants was credited to Capital Reserve Account.
The Company had allotted 23,26,110 Convertible warrants of Rs. 32/- each (Rs. 8.00 per warrant paid on allotment) on preferential basis to Promoters/Directors, their friends and relatives on 29 th July 2009. Of the above, 8,20,222 warrants were converted on 11 th September 2009 and balance warrants 15,05,888 were converted on 27 th October 2009. The balance amount of Rs. 24 per warrant was duly received before exercise of warrants.
Investors may read our complete analysis of ADF Foods Ltd in the following article: Analysis: ADF Foods Ltd.
Promoters of another company, IOL Chemicals and Pharmaceuticals Ltd also refused to exercise their warrants when the stock price of the company declined.
While analysing the issuance and exercise of different incidences of allocation of warrants by IOL Chemicals and Pharmaceuticals Ltd, an investor comes across instances, where the promoters did not exercise their warrants and let them expire.
FY2012 annual report of IOL Chemicals and Pharmaceuticals Ltd, page 33:
The allottees of 15,00,000 warrants expressed their unwillingness to convert these warrants to equity shares. The Company, in accordance with SEBI guidelines for preferential issue, forfeited ₹ 210 lacs, the amount paid by the allottees for these warrants
When an investor studies more about these warrants, then she notices that these warrants were issued on January 16, 2010, at an exercise price of ₹56 per share. However, shortly after the allotment of the warrants, the share price of the company started declining. By March 2012, the share price of the company had declined to ₹25/-.
An investor would appreciate that it does not make any economic sense for the promoters to buy shares from the company by exercising the warrants at ₹56/- when the market price is only ₹25/-. As a result, the promoters expressed their unwillingness to exercise the warrants to the company.
Because of refusal of the promoters to exercise 15,00,000 warrants priced at ₹56/-, in FY2012 the company could not receive the 75% of the money due on the exercise of warrants i.e. ₹6.3 cr. (= 15,00,000 * 56 * 75%).
Moreover, in FY2012, IOL Chemicals and Pharmaceuticals Ltd defaulted to Punjab National Bank (PNB) for its dues of about ₹4.77 cr as it did not sufficient amount of money to repay its debt.
FY2012 annual report of IOL Chemicals and Pharmaceuticals Ltd, page 35:
The Company has defaulted in repayment of loans and interest in respect of the following: (Particulars as at 31 March 2012): Term loans from banks: Punjab National Bank
- Principal (Jan – March 2012): 3,14,42,000
- Interest (Feb 2012): 1,63,02,423
- Total: 4,77,44,423
It was not the first instance when the promoters of IOL Chemicals and Pharmaceuticals Ltd declined to exercise the warrants allotted to them. Previously, in FY2009 as well, when the share price of the company declined sharply, then the promoters chose not to exercise the warrants and let them expire.
FY2010 annual report of IOL Chemicals and Pharmaceuticals Ltd, page 33:
Other income in year ended March 31, 2009
- Equity Warrants forfeited ₹96,42,000
The following chart shows the share price movement of IOL Chemicals and Pharmaceuticals Ltd from January 2008 to March 2009.
Investors may read our complete analysis of IOL Chemicals and Pharmaceuticals Ltd in the following article: Analysis: IOL Chemicals and Pharmaceuticals Ltd.
Therefore, an investor would appreciate that when promoters attempt to structure infusion of their contribution by way of warrants, then they would give the entire money to the company only when the promoters make a profit by way of buying the shares at a cheaper price from the company than the prevailing share price in the market. If the price in the market is lower, then the promoters hesitate to exercise the warrants even if the company is in severe liquidity stress and may default to the lenders.
These incidences proved the concerns of the minority investors about preferential allotment of warrants to promoters that promoters use warrants to benefit themselves ahead of minority shareholders.
Therefore, we believe that the condition of paying only a part of money upfront at warrant allotment and the condition of payment of the balance money at the exercise of warrants puts the odds highly in the favour of the promoters who will exercise the warrants only when they are making profits on the warrants.
When Share warrants are allotted above market price
The exercise price in the warrant allotment is based on a formula, which takes into account the average share price of shares in previous six months. Therefore, at times, investor may come across situations where the warrants are allotted to the promoters at a price, which is higher than the market price of the shares of the company on the date of warrant’s allotment.
However, as explained above, we believe that any such instrument that involves part upfront payment and balance payment later while freezing the acquisition price should be seen with caution.
Share warrants issued at a premium are still better than those issued at discount to current market price, as at least in the case of issuance at a premium, the interest of the promoters and minority shareholder are somewhat aligned. This is because, now, the promoters will work hard that the share price of the company rises so that they do not lose the money paid on the warrants’ allotment. Nevertheless, the concept of freezing of cost of conversion irrespective of future market price still benefits the promoters at the cost of minority shareholders.
When bankers force promoters to subscribe to warrants
Many times, in the case of a stressed company which is undergoing restructuring, the lenders are happy with whatever amount the promoters bring in in the form of equity. The company is anyway not doing good and not able to honour the commitment to lenders. In such a case, any amount infused is good for lenders. Be it in the garb of warrants or any other form. Moreover, warrants do not dilute lenders’ stake in the company, which is a fixed principal, interest and penalties, if any.
Warrant have different implications for equity holders/minority shareholders and more so in companies, which are not stressed.
- To know about the stocks in our portfolio, you may subscribe to the premium service: Follow My Portfolio with Latest Buy/Sell Transactions Updates
- To learn our stock investing approach “Peaceful Investing” by videos, you may subscribe to “Peaceful Investing” Workshop-on-Demand
- To download our customized stock analysis excel template: Click Here
- Learn about our stock analysis approach in the e-book: “Peaceful Investing – A Simple Guide to Hassle-free Stock Investing”
- Read more company analysis in the e-book series: Company Analyses
- To register for our upcoming full-day “Peaceful Investing” workshop teaching in-depth fundamental analysis & portfolio management: Click Here
- To pre-register free/express interest for an investing workshop in your city: click here
- The above discussion is only for educational purpose to help the readers improve their stock analysis skills. It is not a buy/sell/hold recommendation for the discussed stocks.
- I am registered with SEBI as an Investment Adviser under SEBI (Investment Advisers) Regulations, 2013.
- Currently, I do not own stocks of the companies mentioned above in my portfolio.