Home > Uncategorized > The Impact of Warrants on Restricted Stock Discounts in the Pluris DLOM Database

The Impact of Warrants on Restricted Stock Discounts in the Pluris DLOM Database


The Pluris DLOM Database is a new restricted stock study database that is available to appraisers and can be utilized to quantify the discount for lack of marketability. The database is much larger than other restricted stock studies (i.e. as of December 31, 2011 the database had well over 3,000 transactions vs. approximately 600 in the FMV Opinions Database), primarily because Pluris includes restricted stock transactions issued with warrants. A warrant is a non-tradable option that is often issued in the private placement of restricted stock. Most databases exclude warrant transactions because warrants are difficult to value. Pluris includes them to increase the size of their samples. To my knowledge, very little, if any resesarch has been published on the impact of warrants on the restricted stock discounts in Pluris. The purpose of this post is to report my preliminary findings on the issue. In particular, I will demonstrate the following:

1. The warrant transactions have considerably higher discounts than the non-warrant transactions.

2. The magnitude of the discounts on warrant transactions is affected by the fraction of warrants placed in the transaction;  in particular, the greater the fraction of warrants placed in the transaction, the larger the reported restricted stock discount.

3. The moneyness of the warrant (i.e. whether the warrant is in-the-money, out-of-the-money, or at-the-money) affects the discounts on warrant transactions. In-the-money and at-the-money transactions command significantly higher discounts than out-of-the-money transactions. In addition, I find a strong relationship between the relative moneyness of the warrant (defined later) and the restricted stock study discounts on warrant transactions.

4. Other factors, such as whether the warrants are issued with a cashless exercise or call-cap feature, impact the discounts on the warrant transactions.

5. After controlling for the aforementioned variables, among other factors known to impact the restricted stock discounts, I am able to explain approximately 57% of the variation in discounts on restricted stock transactions issued with warrants.

These issues/findings are discussed further below.

Higher Discounts Observed on Warrant Transactions vs. Non-Warrant Transactions

First, I find that transactions issued with warrants (i.e. 1,655 of the 3,169 transactions) have considerably higher discounts than transactions issued without warrants. This is clearly demonstrated in the graphic below, which summarizes the median discounts on both types of transactions.

As one can see, the median discount on warrant transactions is 29.0% vs. 12.20% for non-warrant transactions. The differential is both economically and statistically significant. Unfortunately, it is unclear why the warrant transactions command considerably higher discounts than the non-warrant transactions (in fact, my initial hypothesis was for the discounts to be comparable). To my knowledge, there is no significant difference in the liquidity of restricted stock issued with or without warrants. Nonetheless, the data suggests that either (a) market participants view warrant transactions to be considerably less attractive than non-warrant transactions or (b) that the warrants are being systematically overvalued by Pluris (overvaluation of the warrants would result in a higher implied discount).

Relationship of Discounts and Fraction of Warrants Placed

In addition to higher discounts, I find a strong, positive, linear relationship between the fraction of warrants placed (i.e. total warrant value expressed as a percentage of total gross proceeds raised) and the size of the restricted stock discount. To demonstrate this concept, I grouped the warrant transactions into 25 equally (or approximately equal) sized portfolio baskets based upon the fraction of warrants placed in the transaction, and computed the median discount for each portfolio basket. The results are summarized in the chart below:

As one can see, there is a strong relationship between the fraction of warrants placed and the observed discounts; that is, as the fraction of warrants placed increases the restricted stock discounts increase. Again, it is unclear what specific economic factor is contributing to this relationship. However, in my opinion, illiquidity is unlikely to be a valid explanation because the fraction of warrants placed should not affect the degree of restricted stock liquidity.

Relationship of Discounts and Moneyness of Warrants

I also find a strong relationship between the discounts on restricted stock transactions issued with warrants and the monenyess of the warrant. The moneyness of the warrant refers to whether the warrant is in-the-money, at-the-money, or out-of-the-money.  The chart below summarizes the discounts on transactions based upon moneyness:

As one can see, at-the-money and in-the-money warrants command significantly higher discounts than out-of-the-money warrants. In addition, I find a very powerful, positive relationship between the discounts and the relative moneyness of the warrants (I define relative moneyness as the stock price less the strike price expressed as a percentage of the stock price). To demonstrate this concept, I grouped the warrant transactions into 25 equally (or approximately equal) sized portfolio baskets based upon relative moneyness, and computed the median discounts for each portfolio basket. The chart below summarizes the relationship:

As one can see, the transactions that have warrants that are deep out-of-the-money (left side of chart) command much lower discounts that transactions that are slightly-out-of-the-money. Moreover, transactions at-the-money command higher discounts than transactions out-of-the-money, and the discounts increase the further the warrants are in-the-money. Again, it is unclear what economic factor is causing this relationship, although illiquidity does not appear to be the answer.

Impact of Other Options Provisions/Features on Discounts

I also find that call caps and cashless exercise features impact the discounts. A call cap refers to a special right that allows the issuer of the warrant to force the holder, under specified conditions, to exercise the warrant once the stock reaches a trigger price. A cashless exercise feature allows the purchaser of the warrant to exercise the warrant without actually paying the strike price in cash.  The table below summarizes the discounts on call cap and non-call cap warrant transactions.

The table below summarizes the discounts on cashless and non-cashless exercise warrant transactions:

As one can see, there is a slight difference in median discounts on transactions issued with call cap and cashless exercise features. Again, it is unclear why these warrant features impact the illiquidity discounts on restricted stock, as neither of the features directly affect the illiquidity restrictions.

Regression Analysis

Based upon the relationships above, and after controlling for other factors known to impact the restricted stock discounts, I formulated a regression equation to explain the variation in discounts on the warrant transactions (1,655 warrants transactions vs. 3,169 total transactions).  The regression equation is summarized below:

DLOM = a +b1*Warrant% + b2*Moneyness + b3*Cashless + b4*CallCap + b5*vol + b6*block +b7*exchange + b8*reg + b9*hp

Where:

Warrant%:   This variable is for the fraction of warrants placed (i.e. warrant proceeds divided by total gross proceeds). This variable is included to control for the observed relationships between discounts and the fraction of warrants placed in the restricted stock transactions.

Moneyness:  This variable is the relative moneynes of the warrant (i.e. stock price less strike price divided by stock price). This variable is included to control for the observed relationship between the moneyness of the warrant and the discounts on restricted stock transactions.

Cashless:   This is a dummy variable to control for the impact of the cashless exercise feature. The variable is set to 1 for warrant transactions with a cashless exercise and 0 for all other warrant transactions.

CallCap:   This is a dummy variable to control for the impact of the call cap feature. The variable is set to 1 for warrant transactions with a call cap feature and 0 for all other warrant transactions.

Vol:   This variable is for volatility of the issuer. This variable controls for differences in the risk of the issuer, which is known to impact the restricted stock discounts.

Block:  This variable is for the fraction of shares placed expressed as a percentage of total shares outstanding. This variable controls for block size, which is known to increase discounts for large block transactions in restricted stock (presumably because the dribble-out provision of Rule 144 make large block sales more difficult).

Exchange: This is a dummy variable to control for the trading exchange of the issuer. The variable is set to 1 for issuers that trade OTC or OTC BB and 0 for all other trading exchanges (i.e. Nasdaq and other National Exchanges)

Reg:  This is a dummy variable to control for registration rights. The variable is set to 1 for transactions issued without registration rights and 0 for all other transactions. We note that certain transactions did not report whether registration rights were included. In those cases, we assumed that the transactions did not have registration rights (primarily because the discounts are comparable to transactions issued without registration rights).

Hp:  This is a dummy variable for the holding period rules applicable to the restricted stock. The variable is set to 1 for transactions occurring after February 15, 2008 (i.e. when the holding period restriction was reduced to 6 months) and 0 for all other transactions (we note that all other transactions were subject to a 1 year holding period).

The table below summarizes the regression output:

As one can see, the regression equation does an excellent job of explaining the variation in discounts, explaining approximately 57% of the variation in discounts on transactions issued with warrants. More importantly, all of the economic variables, except for trading exchange and call cap features, are statistically significant at the 99% level. The call cap feature is statistically significant at the 95% level. The Exchange variable is not statistically significant. The equation provides important perspective on the impact of certain variables on the discounts. In particular, the following:

1. For each 1% increase in the fraction of warrants placed, the discounts increase by 0.8776%. Therefore, a transactions that has 30% of its value attributable to a warrant is expected to have a discount 17.552% higher than a transaction with only 10% of its value attributable to a warrant. This is statistically significant at the 99% level.

2. For each 1% increase in the relative moneyness of the warrant, the discount increases by 0.3177%. Therefore, a transactions that is 100% in-the-money will have a discount 31.77% higher than a transaction in the money. This is statistically significant at the 99% level.

3. Warrant transactions issued with a cashless exercise feature have discounts 2.97% lower than warrant transactions issued without a cashless exercise feature. This is statistically significant at the 99% level.

4. Warrant transactions issued with a call cap feature have discounts 2.01% higher than warrant transactions issued without a call cap feature. This is statistically significant at the 95% level.

5. For each 1% increase in volatility, the discounts increase by 0.0202%. This is statistically significant at the 99% level.

6. For each 1% increase in block-size, the discounts increase by 0.1143%. This is statistically significant at the 99% level.

7. Firms that trade OTC or OTC-BB have discounts 3.37% higher than firms that trade on other major trading exchanges. This variable is not statistically significnat.

8. Transactions issued without registration rights command discounts 5.24% higher than transactions with registration rights. This variable is statistically significant at the 99% level.

9. Transactions subject to a 6 month holding period command discounts 3.34% lower than transactions subject to a 1 year holding period. This is statistically significant at the 99% level.

The most interesting observation, in my opinion, is the significant contribution that the warrant% and moneyness of the warrants have on the discounts. In particular, appraisers could considerably alter the median discounts by “titling” the sample of transactions towards transactions issued with certain option characteristics. For example, if an appraiser wanted to artificially increase the discounts, the appraiser could simply focus on transactions wherein a large fraction of in-the-money warrants was issued. Again, it is unclear whether the relationships are related to illiquidity. In fact, many of the variables (such as warrant% and cashless exercise, among others) appear completely unrelated to illiquidity. Nonetheless, these factors have a large impact on the discounts.

Conclusion

This post briefly examined the impact of warrants in the Pluris DLOM Database. I demonstrate that warrant transactions have considerably higher discounts than non-warrant transactions. More importantly, the magnitude of discounts on warrant transactions is affected by the fraction of warrants placed, the relative moneyness of the warrant, and other warrant features (i.e. cashless exercise and call caps). In particular, both the fraction of warrants and the moneyness of the warrants have a positive and statistically significant relationship to the discounts, even after controlling for many other factors that are known to impact discounts, such as volatility and block size.  In fact, after controlling for these variables, I can develop regression equations that explain approximately 57% of the variation in the restricted stock discount on transactions issued with warrants, and show that many warrant variables, which appear unrelated to illiquidity, impact the magnitude of the discounts. Appraisers should carefully consider the impact of warrants when selecting transactions from the Pluris DLOM Database. It is currently unclear why certain variables impact the discounts and whether these variables are related to illiquidity. Therefore, evidence from the warrant transactions may bias the discounts considerably, and should be approached with caution until valid explanations are found.

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