A Guide to Warrants in Venture Debt
Table of Contents
What are Warrants?
A classic feature in venture debt deals 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.
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?
As with any investment, investors are looking to gain a fair level of return that aligns with the level of risk they are taking. Let’s take a look at different types of funding and the risk/return associated with each.
Starting from the bottom, banks are at the lowest end of the risk/return spectrum. This is because banks invest in deals that are perceived as “less risky.” Deals with lower risk include companies that are larger in size, are generating more revenue, are likely profitable, and have higher asset-backed coverage. Banks also include strict financial covenants which help ensure companies are meeting strict requirements such as debt to EBITDA ratios, interest service, and coverage ratios. As a result of this lower risk, banks are able to offer lower interest rates and no warrants.
At the midpoint, we see venture debt lenders who provide capital to high-growth companies looking to scale up their operations. These companies tend to be higher risk because while they have established a product-market fit and are generating revenue, they are likely not yet profitable and may even lack hard assets (especially if it is a technology or SaaS-based business). As a result of this risk, venture debt lenders require higher interest rates compared to banks and warrants.
At the highest end of the risk/return spectrum we find venture capital. These investors see the highest risk deals because they fund companies that are very early stage. Instead of seeking repayment through interest payments, venture capital investors take a portion of equity with the ultimate goal of getting the company acquired or to go public.
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
Average Warrant Coverage on Venture Debt Deals
Because warrants are a function of the risk/return profile the investor is taking, we often see venture debt deals with double-digit interest rates, less restrictive clauses, and warrant coverage ranging anywhere from 10-20%. The interest rate, terms, and warrant coverage all commensurate with the risk implied in the investment.
Luckily for founders, warrants typically only translate to 1-2% of the company if executed. This is significantly lower than the dilution associated with venture capital funding and only applies if the venture debt lender decides to exercise them. If they do decide to exercise their warrants, they will still need to pay to purchase those shares.
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.
Benefits of Warrants
Warrants offer a range of benefits for both the lender and the company.
- Provides additional participation in the company’s growth and potential in returns
- No upfront costs – payment only happens once the lender decides to exercise the warrants
For the Company:
- Fair pricing – warrants are usually priced at the value of equity at the time of issuance
- Future cash flow – the lender is required to pay for the shares if they decide to exercise the warrants
Disadvantages of Warrants
Along with the great benefits of warrants, lenders and companies are also subject to some disadvantages.
- Finite life – warrants must be exercised on or before the expiry date.
- Fall to zero – the value of warrants can fall to zero once exercised, which can lead to the loss equivalent to the entire investment value
- No control rights – warrant holders do not receive control rights that shareholders have.
- No dividends – warrant holders do not receive dividends, so they are ineligible for dividend payments.
- Future potential dilution – Could result in 1-2% dilution if the holder decides to exercise their warrants.
- If the equity value is higher than the strike price at the time they are exercised – this results in that portion of shares being purchased at a discount.
How are Warrants Priced?
Warrants come with a strike price, which is the predetermined price warrants can be purchased at. The strike price is generally equal to the fair market value of the company’s stock on the day the warrant is issued.
There are three ways to determine the strike price:
- Use the valuation at a recent equity round.
Let’s say Company A just completed raising a Series A round. The company received $20 million and their valuation was $100 million. In order to calculate the strike price of warrants, the warrants would be priced at the equity valuation of $100 million.
- Agree to a negotiated value.
If there was not a recent equity round, the lender and company can agree to a negotiated value.
Company A is looking to minimize dilution and have decided to raise venture debt instead of a Series A round. Because there had not been a recent round of equity and therefore no recent company valuation, Company A and Lender B can work together to come up with a fair valuation.
- Use a discount to a future raise.
The last method is to price at a discount to a future equity raise.
Company A knows they will be raising a Series A in six months, but are closing their venture debt deal this month. In order to determine the strike price of the warrants, Company A and Lender B agree to have the strike price be 20% below the equity value of the upcoming Series A round. For example, if Company A’s valuation at the Series A round is $100 million, the equity value associated with the warrants becomes $80 million.