An essential part of scaling for start-ups and emerging companies is the strategic use of investment tools. Stock options and warrants, while similar, are distinct forms of equity structures that often need clarification.
A warrant is an agreement between a company (“Issuer”) and the holder of the warrant (“Warrantholder”). Warrants entitle the Warrantholder to purchase shares at a specified price within a predetermined period.
What are Warrants?
Warrants are certificates or other instruments issued by a company as evidence of conversion privileges, options, or rights to acquire company shares at a specific price until a fixed expiration date. Since warrants do not typically entitle the Warrantholder to dividends or voting rights, warrants are valuable solely for their profit-earning potential.
Companies commonly use warrants as an inducement to attract investors or leverage favorable deal terms. For example, warrants are frequently used as sweeteners to incent investors to invest or to a lender to loan funds at a more favorable interest rate, whether bank financing or venture debt. Companies may also use warrants when entering into strategic relationships or transactions to encourage the other party to buy into the company’s long-term success.
Although warrants are similar in structure and function to options, the critical difference is that options are typically issued to internal stakeholders, like employees, directors, consultants, and other service providers, and not to external third parties. Since options are typically issued under an option plan, their issuance must conform to the plan terms. On the other hand, warrants are typically offered to external third parties.
The issuance of a warrant is usually evidenced through a document called a warrant certificate. A warrant certificate sets out the essential terms of the warrant, such as:
the exercise price, the number of underlying shares into which the warrants are exercisable, and the term of the warrant;
procedures and conditions for exercising the warrant and
adjustment provisions intended to protect the value of the warrant.
Key Considerations
Types of Shares
Companies must first determine the type of underlying security the Warrantholder will have the right to acquire. In most instances, warrants are issued for common shares. However, in some instances, the Warrantholder may want preferred shares. When issued to investors as a sweetener, the underlying security will typically match the shares purchased by the investor. Outside investors will commonly only invest if the company is issuing preferred shares that have specific rights, privileges, and preferences compared to the common shares.
Number of Shares
The number of shares underlying the warrant may be fixed or expressed as a formula. A formula for calculating the number of shares the Warrantholder may acquire can be a valuable tool to incent a third party, like where the Warrantholder is a strategic sales channel partner.
The warrant could be structured so that the sales channel partner can purchase additional shares if the sales channel partner meets specific sales targets. In addition, a formula may also incent a lender to loan additional funds under an existing credit facility. The number of shares the lender may acquire may increase if the start-up or emerging company borrows additional funds. When using formula or fixed percentage warrants, companies must carefully consider the dilutive effects of any mechanisms that allow for an increase in the number of shares a Warrantholder may acquire.
A company may issue warrants to an investor that will allow the investor to purchase a fixed percentage of shares equal to a fixed percentage of the outstanding equity securities at the time of exercise. Fixed percentage warrants generally do not require price-protection anti-dilution provisions. As the number of shares the Warrantholder can purchase is calculated at exercise, fixed percentage warrants can disproportionately impact other company shareholders, including its founders if the company issues additional shares before exercise by the Warrantholder of the fixed percentage warrant. Companies considering issuing fixed percentage warrants should determine whether there will be any unintended consequences. They should consider if fixed percentage warrants should expire before a specific event like the company’s next financing round.
Exercise Price
A warrant’s exercise price (“Strike Price”) is the price of each share underlying the warrant. The Strike Price of a warrant can vary dramatically. Sometimes, companies set the Strike Price at or above the fair market value of the underlying securities. Other times, the Strike Price is a nominal value, typically called penny warrants. The strike price could be calculated using a predetermined formula or based on the company’s future valuation.
Anti-dilution
The warrant could be subject to anti-dilution, intended to protect the Warrantholder’s right to receive the value negotiated at the time of issuance of the warrant. Specific corporate actions taken by the Issuer during the term of the warrant may dilute the value of the underlying securities, like consolidation of the company’s outstanding shares or distribution to shareholders of additional shares as a dividend. A down round may also trigger price-protective anti-dilution provisions. This happens when the company issues shares at a lower price than sold in a prior round. The formula for determining how the warrants will be adjusted is often a negotiation point for price-protective anti-dilution provisions.
Companies must carefully consider how a down-round will impact the warrant terms. Anti-dilution provisions may adjust the Strike Price and the number of underlying shares exercisable. The adjustment should be proportionate, reflect the triggering event, and put the Warrantholder in substantially the same position but for the triggering event. The Warrantholder and the company must carefully consider how anti-dilution provisions are drafted. This includes ensuring appropriate carve-outs for predetermined events, such as equity issued as compensation, which do not inadvertently trigger the anti-dilution provisions.
Term
Warrants are exercisable up to a specific date, called the expiration or maturity date. The term depends on many factors, including the nature of the deal. A longer-term increases the value of the warrant because there is a greater likelihood of the company’s success over time and a more significant payout as the shares appreciate.
The term may be subject to adjustment if specific fundamental changes happen with the company during the warrant term. Triggering events for term adjustment provisions may include an amalgamation, merger, or disposition of the company’s assets. In the case of these events, the warrant term may accelerate so that each outstanding warrant will, after the completion of such an event, be exercisable for the kind and number of shares that the Warrantholder would have otherwise been entitled to receive immediately before the effective date of the event.
Exercise
Most warrants will be freely exercisable in whole or in part by paying the Strike Price. Some warrants also allow for a cashless exercise. Cashless exercise entitles the Warrantholder to apply the exercise price against the aggregate value of shares it will receive. This is achieved by decreasing the number of shares the Warrantholder will receive by an amount equal to the exercise price that the Warrantholder would have been required to pay for exercising its warrants.