After barely making any money in four years, Somerset Hills Bancorp had its work cut out trying to win over new investors when it needed fresh capital in fall 2002.
So to make a secondary stock offering more attractive, the Bernardsville, N.J., company conducted what is called a unit sale, pairing a share of stock at market price with a warrant to buy another share at a preset price at a future date. It was betting that its performance would improve and that its stock price would rise well above the level set by the warrant.
The offering, completed in November 2002, sold out and raised a badly needed $8 million for the $188 million-asset Somerset Hills.
That success touched off a mini chain reaction. Seven months later the $136 million-asset Hilltop Community Bancorp Inc. in nearby Summit, N.J., sold out a unit sale, raising $4 million.
Now a third in the region, the $177 million-asset Pennsylvania Business Bank in Philadelphia, is considering a unit sale.
Unit sales are extremely rare among community banks because they have several drawbacks, notably that they are twice as dilutive as straight stock sales. Chris Cole, regulatory counsel for the Independent Community Bankers of America, said he knew of no bank that had conducted a unit sale.
But Stewart E. McClure Jr., Somerset Hills' president and chief executive, said they appear to be a good option for young banks eager for investor capital.
Pennsylvania Business Bank has added one branch this year and plans to open another in the next few months, but its expansion has hampered its profitability - it lost $177,000 through the first nine months. That, combined with the stock's relative inactivity, makes a pot-sweetener like warrants very appealing, said Alan Fellheimer, the chairman and CEO.
"The problem with small banks is that they are thinly traded," he said. "We might sell a couple of shares every few months. That is why warrants look so attractive. They offer investors something more than plain, unadulterated stock."
Mr. McClure said he got the idea from Somerset Hills' investment bank, Ryan Beck & Co. of Livingston, N.J. In typical unit sales, the warrant price is set about 20% higher than the current market price, and the investor is usually given three or four years in which to exercise the option.
At Somerset Hills, investors who paid $8.25 per share also received a warrant entitling them to purchase another share within four years at $9.65. The stock closed Monday at $13.70.
Christopher Gastelu, a managing director at Ryan Beck, said, "Investors love warrants." They give an offering "some market sizzle."
Walter G. Moeling 4th, an attorney in Atlanta with Powell Goldstein LLC, said warrants are popular in other industries but cited a number of reasons why most small banks in need of capital pass them over.
For starters, said Mr. Moeling, who has helped a number of community banks raise capital, the market for bank stocks is hot right now, so there is little need to offer extras.
Moreover, warrants bring added dilution and the concern that the bank will end up "leaving money on the table" if its stock appreciates substantially in the period before the warrants are exercised, Mr. Moeling said.
Mr. McClure said he is comfortable with his decision, even though Somerset Hills might have been able to generate more money by holding two separate stock sales instead of selling warrants. He said the $8 million helped his company add branches and products and is largely responsible for its improved profitability.
After netting $173,000 in 2002, the company earned $1.17 million in 2003 and is on pace to post a $1.3 million profit this year.
Barring a collapse in its share price between now and the Nov. 30, 2006, deadline, investors are virtually certain to exercise all the warrants - and that should provide Somerset Hills with another $10 million of capital.
"We have already paid fees and everything, so we will get that money at no extra cost," Mr. McClure said.
Warrants trade exactly like shares, and when the issuing company is doing well, savvy investors will gobble them up.
"Our warrants trade more actively than our stock," Mr. McClure said.
Hilltop's president and CEO, Mortimer J. O'Shea, said his cue to do a unit sale came from Somerset.
"Stew McClure had just done one and it was a successful offering," Mr. O'Shea said. "Imitation is the most sincere form of flattery."
Mr. O'Shea said the fact that Hilltop sold out without using an underwriter shows the allure of warrants.
"A unit offering appeals to the more savvy investor," he said.
Hilltop's stock has appreciated considerably over the past 15 months, jumping from $8.50 at the end of July to a close of $13.70 Monday. That means Mr. O'Shea can count on another infusion of capital when the warrants expire in April 2006.
"That will help us sustain our growth," he said.
Mr. Fellheimer said what he likes most about warrants is the prospect of receiving a second round of capital.
"It's like a time-release capital pill," he said.
Things do not always go as smoothly as they did for Somerset Hills and Hilltop.
Robert E. Kafafian, the president and CEO of the bank consulting firm Kafafian Group Inc. in Parsippany, N.J., said he underwrote a unit sale for a Maryland community bank several years ago, but it continued to struggle even after the capital infusion.
"It has not performed well and its warrants were never close to being in the money," he said.
Even so, Mr. Kafafian said, warrants "are probably something other community banks would want to consider."
