Option Or Warrant: Alternative Structures For A Future Acquisition

Posted November 15th, 2016 by Samantha Truex, in Business Development, From The Trenches


This blog was written by Samantha Truex, former CBO of Padlock Therapeutics and Atlas Entrepreneur-in-Residence, as part of the From The Trenches feature of LifeSciVC.

The search for creative deal structures that strike a “win-win” balance is a noble one. In a recent quest for such a balance, I delved into a detailed comparison of structures leading to an acquisitions and subsequently received requests from multiple companies for input on these structures.

Given those requests, I thought it would be useful to share a couple of the lessons I learned on this somewhat dry, yet important topic.

Lesson oneprovide a disclaimer.  Here’s mine: the following comments provide a high level view of pros and cons from the perspective of a US individual taxpayer.  You should delve into the specific benefits and risks of your situation with knowledgeable counsel and accountant input before coming to any conclusions about a particular deal. I learned an enormous amount about this topic while working recently with the great team from Goodwin Procter, whom I thank for these insights. I know they agree that you need to asses more details than I’ve provided in this overview before choosing a structure.

Lesson two – option or warrant.  A contractual opportunity to acquire a company can be structured as an option or as a warrant. The option structure is more commonly used, yet the warrant can have tax benefits for shareholders in certain circumstances and is worth considering before finalizing a structure. This distinction is especially important if a goal of the transaction is to return some of the funds paid for this option/warrant to shareholders.

Option Structure:

  • BigCo purchases an option to acquire SmallCo at a later date.  The option is purchased from SmallCo shareholders for an option premium.  The option premium funds can be used to fund the company or paid directly to  shareholders as return on their investment – or divvied up across those two uses.  This feature can be viewed as a pro if that is a goal of the transaction.
  • If the deal includes an infusion of cash from BigCo to SmallCo for operating purposes, SmallCo and BigCo will need to determine how much of the overall cash flowing into the company will be treated as the option premium.  There will likely be healthy tension on that front due to the implications for BigCo’s P&L and SmallCo’s shareholders’ tax and accounting burdens.
  • The option premium is not taxable to SmallCo shareholders at the time of the option transaction.  Instead, it becomes taxable upon SmallCo shareholders at the time of the option exercise trigger point.  This delay in tax burden can be viewed as a pro.  But keep reading the fine print, which is actually in the same font.
    • If the option is exercised, at that point the option premium becomes taxable to SmallCo shareholders as capital gain., generally at the preferable long-term rate as long as the shares purchased by BigCo on exercise of the option were held for longer than a year.  This treatment is a pro.
    • If the option is not exercised, then the option premium becomes taxable to shareholders as short term capital gain at higher tax rates (sometimes called the “option penalty”), whether the shareholders received any of the option premium or not.  This is a really important con.  SmallCo can, if it chooses, make a distribution to shareholders to cover this tax bill if it has enough cash on hand at the time.

Warrant Structure:

  • BigCo purchases a warrant from SmallCo to acquire a newly-created special class of SmallCo preferred shares at some point in the future.  BigCo pays SmallCo for the warrant (“warrant consideration”) and  SmallCo’s charter documents are amended to provide that all SmallCo equity other than that special preferred class will be redeemed by SmallCo at some future trigger point for an agreed-upon price if BigCo exercises the warrant.  The idea here is that the only outstanding SmallCo shares left after warrant exercise are the special class then owned by BigCo, so SmallCo becomes a wholly owned subsidiary of BigCo.  And, voilà, BigCo’s warrant serves as the opportunity to acquire SmallCo upon some trigger.
  • Just as for the option described above, SmallCo and BigCo will need to determine how much of the warrant consideration will be treated as warrant purchase price.  Again, there will likely be healthy tension on that front.
  • The upfront warrant consideration comes to SmallCo directly. If the warrant is not exercised, the warrant purchase price is not intended to be taxable to SmallCo or its shareholders. Compared to the option structure, this is a really important pro and one to keep in mind if a key purpose of the upfront payment (or other pre-exercise payments) is to fund SmallCo’s operations for some period of time.
  • In some cases, a portion of the warrant consideration received by SmallCo can be distributed to shareholders, though the tax and corporate considerations around this are very complicated and fact-specific. Any distribution to shareholders is taxed at the time of distribution. The attractiveness of this approach depends completely on SmallCo’s past financial history and forecast, and other facts at the time of the transaction.

This has been a rather technical blog, yet hopefully one that can serve as a reference for some of you in the future.

What would a major deal be without a significant accounting or tax issue to wrestle? Don’t forget the disclaimer.  These are complex structures where good counsel and accounting expertise are critical.

 

This entry was posted in Business Development, From The Trenches and tagged , , . Bookmark the permalink.