What is an equity warrant?
A warrant is the right to purchase or sell something at a specified price. In venture finance, the most common type of warrant is an equity warrant (also known as a stock warrant) granted to a lender as part of a financing arrangement.
An equity warrant gives a lender the right to purchase a percentage of the company (typically between 1-5%) or a specified quantity of stock at a set price per share (e.g. exercise price). They are similar to a call option in the stock market.
Why do lenders use equity warrants?
Lenders sometimes use equity warrants as an alternative way to yield higher returns on the money they lend to companies. This allows the lender to offer lower interest rates as the potential upside of a warrant offsets their risk of lending.
However, while warrants have a high potential for return, they are risky investments. In the world of venture finance, warrants can also have a rather large downside for the borrower.
How is a warrant exercised?
Unlike call options that usually only last for a short period of time, warrants often last up to 10 years and can have exercise prices as low as $0.01 per share. Yes, that’s practically free stock.
When a company has a liquidity event, such as an IPO or private sale, the venture lender will be allowed (or required) to exercise their warrant as long as the price per share is above any set minimum “strike price.”
If the price per share is not above the strike price, they must wait for another liquidity event before they can exercise their warrant.
How lenders make money on the warrant.
After purchasing the shares at the warrant’s exercise price, lenders have the ability (often obligation) to sell those shares immediately at the sale price. The difference between prices is pure profit for the lender.
If the founders and other shareholders still owned the rights granted by the warrant, they would have realized this additional profit. This is why the trust cost of capital when a warrant is involved is impossible to predict.
When a company doesn’t perform as hoped, lenders oftentimes have additional protections for their investment. This protection is usually in the shape of a “put option.”
The Put Option
Also known as a “warrant put,” the put option gives the lender the right to sell the warrant back to the borrower for a specified amount of cash known as the “put amount”.
These options can usually be exercised a few years after the loan is issued or after the end of the term.
Think of the put amount as a guaranteed minimum for the lender. If a lender doesn’t want to hold the warrant any longer, they can simply put the warrant. Therefore, it is important a borrower expects to have to pay this amount.
If you give a warrant of 1% of your company and there is a put amount of $30,000, expect to pay at least $30,000.
A lender may want to exercise a warrant put at a time the company really needs cash, which can impact your company’s growth or financial strength.
Often, it is in the company’s best interest to refinance the put amount with another loan, further increasing their cost of capital.
Ultimately, warrants lead to widely varying costs of capital for borrowers. It is a diversification technique that allows lenders to get greater returns from the companies that do the best, but often at the expense of those companies.
If your company accepts an equity warrant and grows very well, the warrant will most likely increase your cost of capital far beyond financing options without warrants.
Interested in calculating the cost of capital on a loan with an equity warrant?
Pros and cons of equity warrants to borrowers:
- Lower initial cost of capital.
- Lower interest rate can be beneficial for growth.
- Can cause a permanent place on your balance sheet / cap table – you don’t want too many of those hanging around and diluting you.
- Having many shareholders can be hard to manage, simple things become more painful e.g. shareholder approvals take longer.
- Risk of having a ‘bad’ or uncooperative shareholder.
- Warrant put might come due and hurt cash-flow when you need it most.