The holder of one warrant can exercise it in order to purchase one share share of common stock by paying the fixed exercise price. Price protection simply means that there are conditions that could reduce the exercise price, allowing the investor to exercise and purchase shares at cheaper prices. The price protection clause benefits warrant holders significantly at the expense of existing shareholders as they are diluted at a lower valuation. This is also why fundamental investors dislike companies that have significant existing warrants in their capital structure because the additional dilution reduces a stock's potential upside.
The following are the most common types of price protection clauses ranked in terms of toxicity to existing shareholders.
Cashless exercise at Black-Scholes value
This type of price protection allows the warrant holder to get "free" shares by exchanging each warrant for common shares at a ratio determined by a formula.
Each warrant is valued by the Black-Scholes model, just like how a call option is priced in the options market. The inputs to the model are predetermined in the warrant contract when it is issued (usually significantly overpriced using upward biased inputs).
Suppose this warrant is valued at $1 per warrant by the model. The holder can then trade in this $1 value for an equivalent $ value of shares. If the stock price is currently at $1, then they can exchange 1 warrant for 1 share. If the stock price is $0.2, then 1 warrant exchanges for 5 shares. As you can see, this causes a downward spiral situation where more shares are given as the stock goes lower, making it the most toxic form of price protection. MULN, CENN, and BRQS were companies that were dragged down by this type of warrant price protection. The result on the stock price is a persistent sell pressure from new shares being issued on the daily.
Alternative cashless exercise
This clause reduces the exercise price to ZERO under certain conditions. This means that the holder effectively gets additional shares for free! The most common condition is if the stock price is below the exercise price after x number of days. The end result is that the moment the condition is met, the warrant holder will get their free shares and dump on the open market to lock in their gains. It is advisable to wait until such warrants are exercised before even considering an investment.
See below for an example on SMFL after its IPO. 1.6m warrants issued in the IPO contained cashless exercise provisions where holders could cashless exercise if $10m dollars traded since IPO or after 10 days. This condition was met on day one so they could get their free shares on day 1 and sell right away causing downward pressure.
Full Ratchet (down round protection)
This clause causes the exercise price of the warrant to be reduced to the latest offering price if it is lower than the existing exercise price.
For example, if the exercise price was previously $5 and the company does an offering by issuing 5m shares at $1, the old warrants with full ratchet protection would have its exercise price reduced to $1 as well. This is meant to "protect" the old warrants by giving them a better chance of getting exercised in the future since the exercise price is reduced significantly.
Using SMFL again, old warrants with $6.25 exercise price were reduced to $0.35 and the number of warrants also increased by the inverse proportion. The proportional increase in warrants doesn't always exist and is a separate clause in the warrant contract.
In this case, 214m warrants at $0.35 is a significant amount that could act as a wall and deterrent to a rise in the stock price.
Reset after a trigger condition
If this condition exists, then the exercise price of a warrant can be reset to a recent price should some event occurs. The most common events are after a reverse split and X number of days after issuance.
The below example shows how PALI's warrant exercise price was reduced after the reverse split and the holders were able to exercise such warrants for a profit.
Manual adjustment by the company
All warrant exercises prices can be manually reduced by the company, therefore this clause is not explicitly shown on the DT site under the price protection field.
The company may choose to reduce the exercise price below the current stock price in order to entice the holder to exercise, which allows the company to raise some short term funds if they are desperate for cash. In some cases, more warrants are issued as a bonus to further induce the holders to exercise. The market impact is a one time drop on the announcement of the exercise, much like the result of an offering.
KPRX announced a warrant inducement that reduced 654k old warrants' exercise price to $4.77 and issued the same amount in new warrants. This is almost economically equivalent to doing an offering at $4.77 with 100% warrant coverage.
Standard cashless
This clause allows the warrant to be cashless exercised if there is no registration statement filed within a certain time period. 99% of warrants contain such a provision so it is also not explicitly shown on the website. It is not as toxic because this clause is only usable after the stock price goes above the exercise price. For example, if there is no registration statement and the stock price is currently at $12 while the exercise price is $10, the holder can cashless exercise a warrant to lock in the $2 intrinsic value by receiving $2 worth of shares ($2/$10=0.2 shares per warrant). This means the holder needs to exchange 5 warrants in order to receive 1 share.
Conclusion
Warrants are complex derivatives and can have significant impact on a stock's tradable float. Understanding price protection is important because it will help you know with higher confidence if new shares are hitting the market and under what conditions can it do so.