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Cashless Exercise Warrants Can Improve Investor Liquidity

Winter 1995

Investors often receive warrants to purchase common stock as part of a debt or equity financing package provided by the investor to an issuer. When the warrant is exercised for cash, a new holding period commences under Rule 144 for the resale of the common stock. Under Rule 144, an investor must hold the common stock for at least two years before the stock can be sold in the public market. This delay can be a significant impediment to an investor’s liquidity.

Investors can rely on registration rights to sell warrant shares prior to the end of the two-year period. Shares subject to registration rights, however, are not as liquid as unrestricted securities because of the potential delay of SEC registration or the existence of material, nonpublic information about the issuer. Furthermore, under federal securities laws, an investor selling stock pursuant to registration rights could be liable for misstatements or omissions in the issuer’s SEC-filed documents. In such cases, an investor likely would be entitled to indemnification, but the issuer may not have sufficient resources to satisfy its indemnification obligations. For these and other reasons, registration rights may not be the best solution for investors wishing to achieve liquidity.

Another possible way for investors to improve liquidity is to include a "cashless exercise" feature in the warrant. A cashless exercise enables the investor to pay the exercise price by having the issuer withhold stock otherwise issuable under the warrant. For example, assume an investor holds a warrant that is exercisable for 1000 shares of stock at $10.00 per share, and the current market price of the stock is $40.00 per share. A cashless exercise feature allows the investor to receive, upon exercise of the warrant, 750 shares of stock without paying any cash. The other 250 shares (valued at $40/share) are withheld by the issuer in payment of the $10,000 aggregate exercise price.

In the above example, the use of a cashless exercise feature allows the investor to tack the holding period of the warrant to the holding period of the 750 shares. If the warrant had been held for at least two years and if the other conditions to Rule 144 were satisfied, all 750 shares could be sold immediately in the public market without SEC registration.

In a recent no-action letter, the SEC indicated that an outstanding warrant can be amended to include a cashless exercise feature, provided that the investor either does not pay the issuer for making the amendment, or any payment consists solely of securities of the same issuer. If the investor pays for the amendment (other than with securities of the issuer), a new holding period would begin on the date of the amendment.

A cashless exercise has implications for investors subject to Section 16(b) of the Securities Exchange Act. Any shares withheld to pay the exercise price of a warrant would be deemed a "sale" of the underlying stock, matchable with non-exempt purchases either six months before or six months after the warrant exercise.

Investors should request that all of their warrant permit a cashless exercise. In addition, investors should review their existing warrant holdings and amend those warrants lacking a cashless exercise feature.

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