While equity financing from VCs grabs the headlines, debt financing plays an equally important role in funding growth. Debt facilities help startups access capital without diluting ownership or giving up board seats.
However, debt facilities don’t come without strings attached. Most debt instruments include equity components like warrants to compensate investors for the high risk. Let’s learn more about warrants in a debt facility:
- What are warrants
- How do warrants work
- Typical warrant terms by funding stage
- How to negotiate warrants terms
What are Warrants?
Warrants give the holder the right, but not the obligation, to purchase a company’s shares at a pre-determined price sometime in the future. They are commonly included as “equity kickers” in convertible notes and debt facilities. Investors receive warrants so that they can participate in the potential upside if the company does well in the future.
For startups, issuing warrants avoids immediate dilution, but allows investors to benefit from future growth. The two key terms that define a warrant are:
- Exercise Price: The set price per share at which the warrant can be converted into equity.
- Expiration Date: The last date on which the warrant can be exercised.
How Do Warrants Work?
Warrants have an asymmetric risk-reward profile. Investors pay little or nothing upfront to receive the warrants. If the business fails, investors lose nothing from the warrants.
But if the business succeeds, investors can exercise the warrants to purchase shares at the exercise price – which is typically set lower than future anticipated valuations. Essentially, warrants provide cheap upside exposure.
Investors usually wait to exercise warrants until a liquidity event like an acquisition or IPO. But company performance also plays a role. Here are the key variables:
Valuation
Investors want the fair market value per share to exceed the exercise price. The higher the valuation, the more incentive to exercise. Investors like to have penny warrants. They think of warrants as an equity kicker, without any cost to them.
Time Decay
Warrants lose their time value as the expiry date approaches. Investors need to weigh the cost of exercising early versus waiting until an optimal event. Generally, investors ask for a 10 year expiration window.
Acquisitions/IPOs
These liquidity events often trigger warrant exchanges to provide cash payouts to investors. Investors may also want to exercise warrants just beforehand to get liquid shares.
Tax Implications
Exercising warrants triggers a tax bill. Investors factor in capital gains tax rates when deciding optimal timing.
In summary, investors make calculated decisions on if and when to exercise based on their potential return versus alternatives. The terms of liquidation preferences also play a crucial role during later stage rounds.
Warrant Coverage by Funding Stage
Warrant coverage refers to what percentage of the capital invested will be subject to warrants. Generally investors ask for a certain percentage with a cap. Investors strcutrure warrants in 2 ways:
As a % of deployed capital
Investors will earn warrants as a % of per million dollars of deployed capital. This aligns the interests of the startup with the investor. As companies draw the capital, investors earn warrants for the deployed capital. There’s also a downside for investors if the companies choose
Upfront
Here are typical ranges by startup stage:
Pre-Seed Stage
1.5%-5.0% of the company
At the earliest funding stages, warrants usually represent 1% – 5% of the invested capital. Pre-seed deals tend to be the most entrepreneur-friendly. Investors receive warrants as upside while allowing founders to maintain control.
Seed Stage
1%-5% of the company
As founders sell more of their company to raise growth capital, warrant coverage creeps up into the 1% to 5% range for seed rounds. However, warrant exercise prices may remain at or near the seed valuation cap.
Series A
0.5%-3% of the company
By Series A, investors want more equity exposure given increased risk. Warrant coverage norms rise to 0.5% to 3% of invested capital. Exercise prices could be at or slightly above the Series A price per share. Some investors may also negotiate lower exercise prices over time.
Series B
0.25%-2.5% of the company
Series B tends to be a stepping stone round for successful companies en route to an IPO. Warrant coverage intensifies given growth stage risk. Investors may request coverage between 0.25% to 2.5% of capital or higher. The spread in warrant exercise prices also widens compared to earlier rounds.
Beyond Series B, warrant coverage highly depends on specific company performance and investor leverage. Top-tier growth companies can restrict warrants, while others may give reasonable coverage during Series C and beyond.
Negotiating Warrant Terms
Warrants are complex and companies should negotiate terms carefully during fundraises. Here are key considerations:
Minimize Warrant Coverage %
The lower the percentage tied to warrants, the less future dilution. But reasonable coverage is expected, especially for asset-backed debt facilities.
Exercise Price
Companies want higher exercise prices, closer to the implied future value per share. Investors want lower prices to guarantee returns.
Expiration Date
Longer durations (8-10 years) preserve flexibility for investors. Companies may try to limit to shorter 3-5 year periods. Extensions are also negotiable.
Triggers Upon Liquidity
Renegotiating warrant terms is common leading up to a liquidity event. Companies may exchange warrants for payouts rather than force conversions.
Assignability
Companies should block warrant transfers to unknown third-parties. Assignability rights drive future uncertainty.
In conclusion, warrants allow investors to participate in a company’s success without over-diluting founders early on. But excessive warrant coverage can hurt long-term shareholder value. Carefully structured terms that incentivize investors while allowing flexibility are key to balancing risks for both sides.