In startup finance, a warrant is an option to purchase a specific amount of shares of a company at a set price within an established time frame. Understanding the role of warrants is especially valuable for founders looking to raise capital to help fund the growth of their business.
For cash-burning startups, the impetus to seek startup funding sources to acquire capital can come sooner than later. As founders progress through the stages of startup growth, learning how to navigate the fundraising process becomes increasingly imperative. Along with it comes exposure to many new terms unique to startup finance—a vernacular that may be overwhelming to first-time entrepreneurs. In this article, we explain the term “warrant” and its role in startup finance.
With the expertise of Alida Kanani, Vice-President, Credit Advisory, RBCx, we explore the basics of warrants to equip founders with a clear understanding on:
● What a warrant is
● Why warrants are issued
● How warrants can attract investors
● How warrants are used in venture debt
● Important terms to know in warrants
What is a warrant?
A warrant is an option to purchase a specific amount of shares of a company at a set price within an established time frame. The agreement is established between two parties: the company (called the issuer) and the holder of a warrant—typically a lender or an investor.
At the time a warrant is issued, there is no cash exchange or payment by the warrant holder. “It represents a ‘right,’ not an ‘obligation,’ to purchase the shares as set out in the terms of the agreement,” says Alida. Only when a warrant is exercised, will new shares of a company be issued, thereby increasing the overall number of outstanding shares.
“A warrant can ‘sweeten the deal’ for lenders and investors by helping to offset the risk factor by creating a perceived notion of leverage to the warrant holder.”
Why are warrants issued?
Because startups are typically cash-burning and not yet profitable, investors and financial institutions accept a certain level of risk when they provide them equity or debt, especially when compared to the comparatively lower risk of a profitable established business.
“A warrant, however, can ‘sweeten the deal’ for lenders and investors by helping to offset the risk factor by creating a perceived notion of leverage to the warrant holder,” explains Alida. “Lenders and VCs have no foolproof way of picking the ‘winners’ in advance, so they structure their loan or investment in a way that captures an outsized return.”
Warrants also align lender and equity investors on the valuation growth of the company by providing both stakeholders “skin in the game.”
Warrants to attract investors
Early stage startups in pre-seed and seed may issue warrants to help attract investors. Such warrants offer the investor the right to purchase shares at a fixed price (established at the time of issuance) within a certain time frame. This enables an investor to take advantage of price increases with minimal downside risk since there is no obligation to buy if the shares do not appreciate within the set time frame.
While investors can benefit from the potential upside that warrants provide, from a startup’s perspective, warrants represent an additional source of capital in the future (when warrants are exercised in whole or in part by paying the cash exercise price) without the company having to raise a new financing round.
Warrants in venture debt
Warrants are a common loan condition for venture debt which is offered by select financial institutions and non-bank lenders to startups that have recently raised a finance equity round. Because of the increased risk profile of these cash-burning companies, lenders require nominal warrants to provide an upside compensation on the venture debt loan.
“Warrants (in venture debt) are commensurate with the amount of inherent risk that a bank is taking by lending to a high growth, unprofitable company.”
“Warrants are commensurate with the amount of inherent risk that a bank is taking by lending to a high growth, unprofitable company,” says Alida. “On a broader scale, the lender’s total warrant return pool can mitigate venture debt loan losses.” Often warrants go unexercised given the attrition rate of startups. However, she adds, “the diamond in the rough will bring outsized returns to the lender that make up for the losses that will likely occur on other venture debt loans.”
Warrants vs. Options
Warrants and options are similar in that they’re both contracts that give the holder the right to buy stock at a certain price over a specific period of time. The main difference is in who they are provided to. Employees are given options as an incentive to stay with the company, whereas warrants are issued to a lender or investor as part of a financial transaction to sweeten the deal.
Terms to know in warrants
To understand how warrants work and the terms of a venture debt deal, it helps to be familiar with the following basic terminology.
Allocation: This is the number of shares included in the warrant that the holder can purchase when—and if—they exercise the warrant. It may be a fixed amount or expressed as a formula. In venture debt, warrants are often expressed as a percentage of the company’s fully diluted shares.
Fully diluted shares: Fully diluted shares are the value of all the company’s common shares, including:
● Common shares currently issued and outstanding
● Preferred shares converted to common shares
● SAFEs (Simple Agreement for Future Equities)
● All shares on reserve that could be claimed through the exercise of options and warrants
Venture debt warrants tend to be 5 to 50 basis points (bps), or 0.05% to 0.5%, of the fully diluted shares. The percentage will vary based on the startup’s stage to reflect the level of risk to the lender—typically, the higher the risk, the higher the bps, and vice versa.
Strike or exercise price: This is the price at which a warrant holder can purchase shares, and is established at the time of the transaction or issuance using the most recent startup valuation of the company. “It’s typically the fair market value of the shares at the time the warrant is granted, determined from the most recent round of financing,” says Alida.
Expiration date: This is the last day you can exercise a warrant. The right to purchase the predetermined number of shares can last anywhere from one to 12 years, as per the warrant agreement. Typically the expiration date of warrants issued to investors are shorter than those issued to lenders. Unexercised warrants are not worth anything after the expiration date.
Exercising a warrant
Warrants are only exercised when the current market price of a company is higher than the strike price. Holders have the option to redeem the warrant by buying the shares of a startup for a lower price than they are worth today. For warrant agreements established with lenders, warrants are typically exercised upon a liquidation event, such as a merger and acquisition (M&A) in which the shares of the company are purchased by an acquirer, or an initial public offering (IPO) in which shares are issued to the public.
“At either of these points in time, if the valuation is higher than the strike price, the warrant is considered to be ‘in the money’ and is exercised,” says Alida. If the underlying shares of the company don’t surpass that of the strike price of the warrant, they expire.
For example: A venture debt warrant has a maturity time of 12 years. At the end of the 12 years, the company has not been bought out by another company, there has been no IPO, and the company value has gone down. The warrants are, therefore, worthless and the warrant is not exercised.
In circumstances when the value has gone up, and the venture debt warrant is exercised by the lender, it’s always on a cashless basis. “The capital required to purchase the shares is deducted from the capital gain,” says Alida.
If the company has been acquired by another business, and the acquirer pays in stock, “the warrant will typically then be exercisable on the acquirer’s stock until the warrant’s expiration date,” says Alida.
Example of exercising a venture debt warrant
Company XYZ has a post money valuation of $60 million after an equity round. It has 5 million fully diluted shares and the current price per share is $12.
5 million shares x $12 = $60 million
The company is looking to receive $8 million in venture debt. As part of the venture debt proposal, a financial institution requests 25 bps of warrants allocation. A year later, XYZ is acquired by ABC Corp for $100 million. The company still has 5 million fully-diluted shares, but the share price has increased from $12 to $20 per share.
5 million shares x $20 = $100 million
The financial institution exercises the warrant at the $12 strike price, receiving 12,500 shares for $150,000.
5 million shares x 0.25% (25 bps)= 12,500 shares
12,500 shares x $12 strike price = $150,000 purchase price
The proceeds are $20 per share, totalling $250,000.
12,500 shares x $20 = $250,000 proceeds
The net gain for the lender is $8 per share, or a total profit of $100,000.
$250,000 – $150,000 = $100,000 profit
Warrants are a win-win
Warrants are a win-win for both a startup and its warrant holder. “Not only do they serve as a tool to get better terms on an equity round or a venture debt transaction,” says Alida. “They also can provide a company access to additional capital if warrants are exercised, without giving up a significant amount of ownership in the company.”
For most companies, warrants will never be exercised as the business will not grow past their strike price. In this case, the outstanding debt from the lender can still be repaid if the company raises another round of financing at a lower valuation, has a liquidation event, or through sustainability of cash flows.
“On the other hand, if the holder decides to exercise their warrants, this means the company is performing well,” says Alida, “providing an upside for the lender that leaves the startup with one to two per cent ownership dilution compared to upwards of 20 per cent (dilution) that would be given up for an equity financing round.”
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