From time to time, when startup founders are negotiating startup financing—debt or equity—the investor may request warrants. This article breaks down the key points that a founder should understand about a warrant.
What Is a Warrant?
A warrant is a type of security that gives the holder the right to buy stock at a certain price, known as the exercise price, within a specific time frame. Warrants are often used in startup financing as an additional incentive for investors.
In startup financing, warrants can be used to sweeten the deal for investors or lenders who might be hesitant to invest in a new company without some sort of guarantee of future success. By offering warrants along with equity in the company, startups can provide investors with an additional upside if the company grows.
Warrants can dilute existing shareholders’ equity if they are exercised. However, if the company performs well and the stock price rises above the exercise price of the warrant, it can still be a win-win situation for both investors and existing shareholders.
Warrants vs Stock Options: Key Differences
Warrants and stock options are similar in structure and terms. However, differences arise in high-growth emerging companies. Stock options are commonly given to employees and service providers as an added incentive. Warrants, on the other hand, are issued to incentivize a third party to enter into a financial or commercial transaction. For example, warrants may be issued to investors or banks providing financing, or to commercial or strategic partners. The potential upside creates aligned incentives between parties.
Option plans typically only allow for issuances of options to individuals providing services, with rare exceptions. Issuers can’t grant options under their existing option plan to third-party investors, lenders and commercial partners.
How Are Warrants Used in Startup Financing?
Warrants can be a useful tool for both startups and investors in financing rounds. In startup financing, warrants are typically issued alongside preferred stock to sweeten the deal for investors. They provide investors with the option to purchase additional shares at a later date, typically at a lower price than the current market rate.
This can be advantageous for both parties: investors have the potential to increase their returns if the company performs well, while startups can attract more investments by offering these potentially lucrative incentives.
Warrants also give investors some protection against dilution. If the company raises more capital in subsequent rounds of funding, then the value of their initial investment could decrease as their ownership percentage is reduced. However, if they hold warrants, they have the option to increase their stake in the company and maintain their ownership percentage.
Warrants can be complex financial instruments and should be carefully considered before being included in any financing round. Startups should consult with legal and financial advisors to ensure they fully understand the implications of issuing warrants and how they fit into their overall financing strategy.
What Are the Benefits of Using Warrants in Startup Financing?
Warrants can be a valuable tool for startups seeking to raise capital. By offering warrants alongside equity, startups can incentivize investors to invest in their company and help them achieve growth. Here are some of the key benefits of using warrants in startup financing.
- Attracting Investors
Investors often look for additional incentives when deciding whether to invest in a company. By offering warrants, startups can attract more investments by providing investors with the potential for additional returns if the company performs well.
- Mitigating Dilution
As mentioned earlier, when a company raises more capital, existing shareholders’ ownership percentage is reduced, resulting in dilution. However, if investors hold warrants, they have the option to increase their stake and maintain their ownership percentage.
- Flexibility
Warrants offer flexibility for both startups and investors. Startups can structure warrants in various ways to meet their specific needs while still providing an attractive incentive for investors. Meanwhile, investors have the flexibility to exercise their warrants at any time within a specific time frame or sell them on the open market.
- Aligning Interests
Warrants align interests between startups and investors as they provide an added incentive for both parties to work toward increasing the value of the company. When investors hold warrants alongside equity, they have a vested interest in helping the company succeed since they stand to benefit from any future growth.
Overall, while there are risks associated with issuing warrants, they can also provide significant benefits for startups looking to raise capital and attract new investors. As always, it’s important for founders to consult with legal and financial advisors before making any decisions about including warrants in their financing strategy.
What Are the Risks Associated With Using Warrants in Startup Financing?
While warrants can be an attractive incentive for investors and startups alike, there are several risks associated with their use in startup financing.
Firstly, issuing warrants can dilute existing shareholders’ equity if they are exercised. This means that if the company does well and the stock price rises above the exercise price of the warrant, more shares will be issued to the investor who exercises their warrant. This increases the number of outstanding shares and reduces the ownership percentage of existing shareholders.
Secondly, warrants can be complex financial instruments that require careful consideration before being included in any financing round. They may have different terms and conditions compared to other securities, such as preferred stock or common stock. Startups should consult with legal and financial advisors to ensure they fully understand the implications of issuing warrants and how they fit into their overall financing strategy.
Thirdly, there is no guarantee that a company will perform well or that its stock price will rise above the exercise price of a warrant. If this happens, then the warrant may expire worthless, leaving investors with no return on their investment.
Lastly, warrants can create conflicts between investors and startups over valuation. Because warrants have a strike price (the exercise price), which is typically lower than the current market rate for shares at issuance, it can be difficult to determine how much value they add to a financing round. Investors may argue that they should receive more equity or a lower valuation because of the potential upside from exercising their warrants.
Overall, while warrants can provide benefits for both startups and investors in financing rounds, it’s important to carefully consider their use and potential risks before including them in any deal.
What Are Some Common Terms to Include in a Warrant Agreement?
When including warrants as part of a financing round, it’s important to ensure that the warrant agreement includes all necessary terms and conditions. Some common terms that may be included in a warrant agreement include:
- Exercise Price: The price at which the warrant holder has the right to purchase shares of stock.
- Method Of Exercise: Warrants can be exercised in full or in part by paying the cash price. Many warrants also offer a “cashless exercise” option that allows holders to exercise without paying cash. Instead, the number of shares received is reduced by the value of the exercise price. This is sometimes called a “net exercise.”
- Expiration Date: The date by which the warrant must be exercised; otherwise, it will expire worthless.
- Vesting Schedule: The timeline for when the warrants become exercisable by the holder. This could be immediate or over a period of time (e.g. vesting over four years with a one-year cliff).
- Anti-Dilution Provisions: These provisions protect investors from dilution if additional shares of stock are issued at a lower price than the exercise price of their warrants.
- Transferability Restrictions: These restrictions prevent the transfer or sale of warrants without prior approval from the company.
- Call Provisions: These provisions allow the company to call back or redeem outstanding warrants under certain circumstances.
It’s important for startups and investors to carefully consider these terms and negotiate them as part of any financing deal. Warrant agreements can be complex financial instruments, so it’s crucial that both parties fully understand how they work and what their implications are. Startups should consult with legal and financial advisors to ensure that their warrant agreements are structured in a way that is fair and beneficial for all parties involved.
How Do Warrants Impact a Startup’s Cap Table and Overall Ownership Structure?
Warrants can have a significant impact on a startup’s cap table and overall ownership structure. When an investor exercises their warrant, they are essentially purchasing additional shares of the company at the exercise price. This increases the number of outstanding shares and dilutes the ownership percentage of existing shareholders.
For example, let’s say a startup raises $1 million in funding by issuing 1 million preferred shares at $1 per share. If the company also issues warrants that allow investors to purchase an additional 100,000 shares at $2 per share, then the fully diluted capitalization of the company would be calculated as follows:
- Preferred shares issued: 1 million
- Warrants exercised: 100,000
- Fully diluted shares outstanding: 1.1 million
In this scenario, if all warrants are exercised, existing shareholders’ ownership percentage would be reduced from 100% to approximately 91%. This means that founders and early employees could potentially see their ownership stake significantly reduced if investors exercise all their warrants.
It’s important for startups to carefully consider how many warrants they issue and at what exercise price. They should also think about how these warrants fit into their overall financing strategy and how they may impact future rounds of funding.
How Can Startups Negotiate the Terms of a Warrant Agreement to Minimize Risk and Maximize Benefits?
When negotiating a warrant agreement, it’s important for startups to keep in mind the potential risks and benefits for both parties involved. Here are some strategies that startups can use to negotiate favorable terms:
- Set a Realistic Exercise Price
One key factor in negotiating a warrant agreement is setting a realistic exercise price. Startups should consider their current valuation and future growth potential when determining the exercise price. If the exercise price is set too low, it could lead to significant dilution of existing shareholders’ equity if the company performs well. On the other hand, if it’s set too high, investors may be hesitant to invest in the company.
- Consider Anti-Dilution Provisions
Anti-dilution provisions can protect investors from dilution if additional shares of stock are issued at a lower price than the exercise price of their warrants. However, these provisions can also be difficult to understand. Startups should consult with legal and financial advisors to ensure that any anti-dilution provisions are structured in a way that is fair for all parties involved.
- Negotiate Transferability Restrictions
Transferability restrictions prevent the transfer or sale of warrants without prior approval from the company. These restrictions can be an important tool for startups to maintain control over who holds their securities and prevent unwanted third-party investors from acquiring large stakes in the company.
- Include Call Provisions
Call provisions allow the company to call back or redeem outstanding warrants under certain circumstances. This can be beneficial for startups if they want to reduce their overall outstanding securities or limit ownership by certain investors.
- Understand Vesting Schedules
Vesting schedules determine when warrants become exercisable by the holder. Startups should carefully consider vesting schedules when negotiating warrant agreements, as they can impact investor incentives and alignment with company goals.
By following these strategies, startups can negotiate favorable terms in their warrant agreements that minimize risk and maximize benefits for all parties involved. It’s important for startups to consult with legal and financial advisors throughout this process to ensure that they fully understand how warrants work and what implications they may have on their financing strategy.
