A Guide to Warrants in Venture Debt
What are Warrants?
Warrants are a security that gives the holder the right (but not the obligation) to purchase company stock at a specified price within a specific period of time. These are issued by the company. Warrants could cause dilution because the company is obligated to issue new stock when a warrant is exercised.
The guaranteed price at which the warrant holder has the right to buy the stock at is often called the strike price or exercise price. However, this price is only valid for a finite time period, during which the warrant can be exercised. Expiration dates can range anywhere from 1-15 years.
Why Are Warrants Used in Venture Debt Deals?
Venture debt is a form of debt financing that involves a principal amount and fixed interest payments. Warrants are used in venture debt deals to further attract lenders/investors. This “sweetener” is attractive to investors because it enables additional participation in the company’s growth. Companies issue warrants because it can bring down the cost of financing (e.g. lower interest rate in venture debt loans) and is a potential source of capital in the future when the company needs to raise more capital.
Elements of a Warrant
Number of Shares: Holders will be entitled to a certain number of shares on or before the expiry date
Strike Price: The pre-determined price warrants are to be exercised at
Expiry Date: The date on or before the warrant needs to be exercised
Advantages of Warrants
For the Company:
- Lower Cost of Financing
- Warrants can be used to lower the cost of financing, such as lower interest rates
- Potential Source of Capital in the Future
- Warrants that are exercised in the future provide the company additional capital at that point in time
For the Holder:
- Additional Participation in the Company’s Growth
- Typically used with medium or long-term investing perspective, companies usually earn high profits in the long term
- Restricted Downside
- While warrants can incur a substantial loss, prices cannot fall below zero
- Low Cost
- Warrants are usually priced at a cheaper rate than the shares
- Capital Management
- Since warrants allow the holder to purchase the shares at a future date, the holder has time to gather the amount of funds required
Disadvantages of Warrants
For the Holder:
- High Risk
- The performance of a warrant depends on the return of the underlying stock, which is volatile to market fluctuations
- Finite Life
- The warrants expire if the holder does not exercise them on or before its expiry date
- Fall to Zero Value
- The value of warrants can fall to zero, leading to the loss equivalent to the entire investment value
- High Loss Possibilities
- Being tied to the company’s stock performance, the holder can either earn a high profit or substantial loss
- Limited Control on the Company
- Warrant holders do not receive control rights that shareholders have
- Ineligible for Dividend Payments
- Warrant holders do not receive dividends
Venture Debt Terms – Warrant Coverage
Warrant coverage in venture debt deals can range anywhere from 10-20%, and largely depends on the risk-level of the company and expected performance of the company.
A venture debt lender provides Company A a $3 million loan with 10% warrant coverage. Company A issues a warrant to the lender for $300,000 worth of shares in the company with an expiry date in 5 years.
The lender now holds a warrant that allows them to invest $300,000 to buy shares of Company A at the price of Company A’s most recent financing round on or before the expiry date.