An Introduction to Warrants
What is a Warrant?
A warrant generally is a contract that gives the holder the right to buy a specified number of shares of stock of a company at a defined price and during a specified period of time. A warrant is to an investor essentially the equivalent of what a stock option is to an employee. Like stock options, warrants have an exercise price and an expiration date (though warrants can be structured to allow those components to become fixed at a later date).
Standard Features of a Warrant
- Underlying Security: Warrants are generally used in startups either as a “kicker” to a lender or an equity investor, or to effect a discount to the issue price of shares of stock. The lender or investor gets a right to buy capital stock at a given price during the term and thus gets to decide later (frequently right before a sale of the company) to invest additional capital in the company, effectively at an earlier valuation.
- Exercise or Strike Price: The strike price for warrants to purchase preferred stock will usually be the same as the original issue price (or a negotiated discount to that price, though discounts have to be addressed carefully to avoid dilution adjustments on shares of preferred that are already outstanding). Generally, the strike price on common warrants will be the common stock’s fair market value.
- Coverage: coverage is the term used to describe the number of warrants that are being issued, usually expressed as a percent of the amount raised. Warrant coverage can vary, but generally companies speak in terms of warrant coverage in deals of between 5 and 20%. For instance, 10% coverage means that for every $100 of investment, warrants to purchase $10 worth of the underlying security will be issued.
- Term: the term is period of time in which the warrant must be exercised. Typically, investors have 5 to 10 years to exercise a warrant. If a warrant expires, the investor loses his or her right exercise.
- Information Rights: Warrants frequently require the company to advise the warrantholder of certain things, such as dividends (which are infrequent), but usually also require advance notice of a sale of the company.
When are Warrants Used…
Warrants are often used together with bridge loans to entice investors to loan the company money for a short period of time to “bridge the gap” between where a company is now and where it needs to be before the next round of equity investment. Warrants can also be used when a company needs to incentivize existing investors to purchase additional shares of preferred stock.
For example, a company that needs additional capital in the short term may offer warrants to investors who purchase preferred stock at the current valuation. Investors who purchase shares now are issued a certain number of warrants – often 10% or 20% of number of shares they are purchasing – giving them the right to purchase additional shares up to 5 or 10 years in the future. Thus, if the company increases in valuation, the investor can exercise (or convert) the warrant and buy shares later at the earlier stock price. Frequently warrants are exercised immediately before a sale of the company when the value of the underlying class of equity becomes clear in the acquisition.
…And What to Watch out for.
There are a number of reasons why companies may not want to issue warrants:
- Warrants are dilutive: warrants dilute the overall value of equity in shares because the company must issue new shares upon exercise. Therefore, the number of outstanding shares of a company on a fully diluted basis increases even though the value of the company remains the same. Similarly, warrants can trigger adjustments in the conversion ratio of outstanding preferred stock classes, depending on the price at which they are issued; preferred stockholders may have approval rights over warrants in the first place, so it is important to not only get consent to the issuance, but a waiver of any dilution adjustment.
- Warrants can last a while: warrants may have long exercise periods, usually 5 to 10 years but sometimes up to 15 years, depending on the type of financing arrangement. During their term, the company will have keep track of the warrants and follow any procedural obligations dictated by the warrant. Further, warrants, though a fairly standard form of document, have to be negotiated, which costs legal fees. Thus, if warrants are being used to give an investor a discount on shares of an existing class of stock (for instance, penny warrants on preferred stock), the company may be better off just issuing the shares at the discount in lieu of the hassle that comes with issuing warrants. Also, warrants will need to be factored into calculations of authorized shares in subsequent equity rounds, and as the cap table becomes more complex, the more likely an inadvertent arithmetic error occurs.
- Company will (likely) never see the exercise price: Warrant holders that are bullish on a company may choose not exercise warrants until much later (usually at an exit), at which point the exercise price is effectively netted against the acquisition consideration and the company never gets the benefit of the strike price.
- Warrants affect Stock Price: Warrants get factored into the company’s fully diluted shares in any subsequent equity round (taking into consideration the strike price). If warrants are issued to effect a discount on equity, that will drive down the price per share of the next round.
- Exit Considerations: if a company does issue warrants, the warrants need to be clear what happens to the warrant at an exit, that the warrants can be properly addressed in a (more or less) self-executing way in a merger agreement and that warrantholders do not have procedural rights that give them undue leverage.