Warrants in Venture Debt
Warrants in Venture Debt
How Warrants Incentivize Debt Investment in Startups
When navigating venture debt fundraises, entrepreneurs may encounter warrants, which venture debt investors use to harness company equity appreciation to boost their returns. Warrants are a security that gives the holder the right, but not the obligation, to purchase company stock at a specified price (called the strike price), during a specified period of time (with the ending of this period of time being called the expiry date, which range from being 1-15 years from the issuance of the warrant). Unlike options, warrants are issued by the lender, not by the company. When warrants are incorporated into a deal, venture debt warrant coverage, expressed as a percentage of the loan amount the lender is providing, is generally 5% - 20%, meaning that the effect warrants can have on a company’s capital structure is material. The remainder of this article explores the advantages and disadvantages of warrants, as well as how these securities are priced.
Pricing Warrants
Warrant strike prices can be priced in three ways:
Using the valuation at a recent equity round: In this case, if Company XYZ just raised a Series A round at a $100 million valuation, the strike price of the warrants would be $100 million divided by the number of shares outstanding. This is how the vast majority of warrant strike prices are determined
Agree to a negotiated value: If there was not a recent equity round, the lender and company may agree to a negotiated strike price
Using a discount to a future raise: The least common method of pricing warrants is to price at a discount to a future raise. In this case, if Company XYZ knows they will be raising a Series A in eight months, but are closing their venture debt deal this week, the two parties might agreee to have the strike price 10% below the equity value of the upcoming Series A round. If the Company XYZ’s Series A valuation is $100 million, the valuation associated with the warrant’s strike price calculation becomes $90 million
Advantages for Lenders
Warrants make an excellent complement to venture debt investors’ double-digit interest rates by providing lenders the opportunity to participate in the company’s growth in equity value and high potential upside
Warrants also help venture debt investors mitigate the heightened risk of startup failure by allowing the equity upside from incredibly successful portfolio companies to compensate for the losses from the 70% - 80% of startups that fail
Unlike the principal loan amount, warrants present no upfront costs to lenders as payment only occurs once the lender decides to exercise the warrants
Warrant strike prices are usually priced at the value of company equity at the time of issuance, giving lenders a significant discount on future equity should a portfolio company have significantly grown in value
Advantages for Companies
Since the lender is required to pay for the shares if they decide to exercise the warrants, the warrants create a source of future cash flow for the company
Accepting warrants is an excellent incentive to entice venture debt investors to invest in the company, especially when considering that most lenders choose not to exercise their warrants unless the company is being liquidated, or sometimes in cases where the expiry date is approaching and the company growing rapidly
Warrants typically lead to only 1% - 2% dilution when exercised, which is far less dilution than founders would incur if taking on traditional venture capital financing
Disadvantages for Lenders
Warrants have a finite life; they can only be exercised on or before the expiry date
Warrant holders receive no control rights that shareholders traditionally have and warrant holders, by definition, are ineligible for dividend payments
Disadvantages for Companies
When exercised, warrants do result in mild dilution. Though the dilution is relatively insignificant, many founders rely heavily on venture debt to retain full ownership of their companies, and in these cases warrants can defeat the purpose of seeking venture debt
If the equity value is higher than the strike price at the time the warrants are exercised, this results in that portion of shares being purchased at a discount
Like all securities, warrants have the potential to shift economic incentives once issued, so careful consideration should always be taken from both parties before approving a deal.