Warrants are very flexible agreements and can be customized for a particular situation. This post provides an overview of private company warrants.
Simply stated, a warrant is an agreement between a company and a lender, investor, vendor or partner (called the “warrant holder”) that enables the warrant holder to purchase a certain number of shares of stock in the company at a specified price (called the “exercise price”) for a specified period of time.
Example. As part of a venture debt financing, Lattamattic issues the lender a five-year warrant to purchase 1,000 shares of common stock of the company at $1.00 per share.
Now let’s look at the various provisions and elements of warrants.
Price of the Warrant
The warrant holder may pay the company for the warrant, but it is often the case that the warrant is issued without a separate purchase price as part of a transaction.
Example. Lattamattic is raising a common stock financing, and wants to provide investors with extra incentive to purchase Lattamattic stock. Lattamattic offers a 5-year warrant to purchase shares of Lattamattic common stock at the price of the financing for any investor investing at least $100,000. The investors don’t pay anything for the warrant – it’s part of the financing and is an incentive for investors to invest $100,000 or more.
When a warrant is issued as part of a financing or other transaction for no separate payment, it is often called an “equity kicker” or a “deal sweetener” because it is being issued as extra incentive to the investor to make the investment.
Shares Covered by the Warrant
A warrant provides the warrant holder with the right to purchase stock of the company. The stock can be common stock or preferred stock. The number of shares can be spelled out in the warrant, or it can be based on a formula.
Example 1. The number of shares covered by the Lattamattic warrant from the above example is based 10% of the number of shares the investor purchases in the next financing round.
Example 2. The Lattamattic warrant issued in the common stock financing is for that number of shares of common stock that equals 10% of the total purchase price paid by the investor for the common stock.
When a warrant is tied to the amount an investor invests in a company, the size of a loan or the size of a transaction, it is called “warrant coverage.” In the example above, the warrant has 10% warrant coverage.
The exercise price, also called the “strike price”, for a warrant is the price per share that the warrant holder will pay for purchasing the shares covered by the warrant. Usually, the exercise price is the fair market value per share of the stock covered by the warrant at the time the warrant is issued. If the warrant is issued as part of a financing round and the warrant is to purchase shares being issued in the round, the fair market value is usually the price per share paid in the round.
Example. Lattamattic is raising a common stock round. The lead investor has negotiated with Lattamattic that the price per share for the common stock issued in this financing is $1.00 per share. Because this value was established by negotiation, the $1.00 per share price is also the fair market value. Warrants issued by Lattamattic to common stock investors will have an exercise price of $1.00 per share.
Note that the exercise price can be any price agreed by the company and the warrant holder. Some warrants have an exercise price of $0.01 per share – these are known as “penny warrants.” However, if a warrant has an exercise that is less than fair market value, there can be tax consequences to both the company and the warrant holder.
Warrants can be for any term, but it is common to see terms from five to ten years. This means that the holder of a five-year warrant can exercise the warrant at any time for up to five years. If the warrant isn’t exercised by the warrant holder before it expires, then if there was value in the warrant when it expires, the warrant holder will lose that value.
In the Money
A warrant is called “in the money” if the fair market value of the stock is greater than the exercise price. If this is the case, the warrant can be exercised and the warrant holder will realize a profit.
Example. Lattamattic issues VC Val a 5-year warrant to purchase 1,000 shares of Lattamattic common stock at an exercise price of $1.00 per share. This means the total exercise price is $1,000. At the end of five years, the fair market value of the stock covered by the warrant is $5.00 per share, giving a total fair market value of $5,000. This warrant is in the money. If the warrant is exercised, the profit to warrant holder would be $4,000 ($5,000 fair market value at the end of years - $1,000 total exercise price).
Some warrants give the warrant holder an alternative to exercising the warrant, called a “cashless exercise” or “net issue exercise.” In a cashless exercise, the warrant holder tells the company that it is choosing to do a cashless exercise, and the company will issue the holder that number of shares that is equal in value to the net value of the warrant. This is calculated by the following formula:
Number of Shares Covered by Warrant * (FMV per share – Exercise Price per Share)
FMV per Share
1,000 shares * ($5.00 - $1.00)
The beauty of a cashless exercise is that the investor doesn’t have to pay the company the exercise price for the stock, and instead receives the net value of the warrant.
Automatic Exercise on Expiration
What happens if an investor forgets that the warrant has a five-year term and the warrant expires? If the warrant is in the money, the forgetful investor loses. One way to protect against “losing out” is for a provision to be added to the warrant that provides if the warrant is in the money at expiration, the warrant will be deemed to be exercised in a cashless exercise and the warrant holder would receive the number of shares as determined by the cashless exercise formula.
Contingent warrants are only effective if a certain event – a “contingency” occurs. A contingent event can be anything: the company meeting or missing a certain annual recurring revenue, a future financing closing on a minimum amount of money, obtaining a patent, etc.
Example. The warrants that Lattamattic issued in the example above are only effective if the company misses its revenue projections for the current calendar year. The warrants are intended to partially compensate the investor for the loss in value of the investment by the company missing its revenue projections. If the company beats its revenue projections, the warrant terminates. If the company misses its revenue projections, the warrants are effective. Missing revenue projections is the contingency, and if the revenue projections are missed, the warrants are effective.
Warrants are used in a wide variety of situations, but here are some common ones:
- Incentive to Invest. As discussed above, a company may issue warrants as an extra incentive (a “kicker”) for investors to invest in a financing round. The warrant can be for some percentage of the investor’s investment. For example, a company may offer a 5% warrant to investors who invest $100,000 or more in a common stock financing. If an investor invests $100,000 at a $1.00 per share of common stock, the investor will obtain 100,000 shares of common stock. In addition, the investor would receive a warrant to purchase that number of shares equal to $5,000 in value (5% coverage * $100,000), or 5,000 shares.
- Venture Debt. Venture debt providers are lenders that provide debt to venture capital-backed startups. Early-stage companies are very risky, and have a high failure rate. Because of this, traditional banks won’t lend to early-stage companies. This is where venture debt comes in. Venture debt providers will typically invest when the company has proven its product is accepted by the market, the company has a meaningful revenue run rate and growth rate, and the company has a stable of well-known and regarded venture capital investors. Venture debt investors will typically require companies to provide them with warrants at the time of the debt transaction, usually at a warrant coverage rate of 5% to 10%.
- Equipment Leasing. Early-stage companies may issue warrants to companies that finance their equipment purchases, very similar to the venture debt situation.
- Convertible Debt. In a convertible debt financing, a company may issue an investor warrants instead of providing a discount in the convertible note.
- Warrants vs. Stock Options. Warrants are very similar to stock options, but there are some key differences. Stock options are issued through a Stock Option Plan, a formal plan that is approved by both the company’s board of directors and stockholders. Stock option plans are used to incentivize officers, employees, board members and others to provide their services to the company. When stock options are issued to employees, they may be “Incentive Stock Options” which provide the employee with certain tax benefits. Warrants are not typically issued to a company’s officers, employees or board members.
- Capitalization Table. Most warrants will appear directly in a company’s cap table. Contingent warrants may or may not be included in the cap table. If they aren’t included in the cap table, there’s usually a footnote to the cap table, and a separate tab in the spreadsheet listing the contingent warrants.
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