What is warrant coverage?
Warrant coverage is contractual provision where a company issues a warrant to an investor that allows them to purchase shares equal to some % of the amount of capital invested, allowing them to acquire shares at a predetermined price in the future. The holder of the warrant has the right, but not obligation to purchase the shares of stock.
Why is understanding warrant coverage important?
Understanding the level of warrant coverage that your investors expect is important because they can leverage it to increase their share of ownership in your company at any time before it has matured—meaning that at virtually any time they can cash in and dilute your equity and the equity of your other existing shareholders. This can be especially dangerous in situations where the company (along with its valuation) is rapidly growing because there can be a large spread between their predetermined strike price and the current FMV strike price of your round.
Why might an investor require warrant coverage?
Investors will do everything in their power to protect their investments. In situations when a higher-than-normal level of risk is present, they pursue various actions to do just that—including seeking warrant coverage. By ensuring that they can purchase shares at a predetermined price in the future, investors can safeguard their current ownership stake against dilution. Early-stage startups typically come with a higher level of risk, hence warrant coverage requirements from early investors.
Why do startups agree to warrant coverage?
There are many reasons why companies offer warrant coverage, the two most significant are to attract more investors and ensure the maximum participation by committed investors.
Startups agree to warrant coverage because it is a fairly straightforward way for them to make an investment in their business more attractive, as investors/creditors get repaid with equity value in exchange for their risk.
Are warrants the same as options?
Warrants are similar to, but not the same as options. There are three primary differences:
- Warrants are typically provided to investors and lenders as stipulations of the deal, options on the other hand are typically offered to early employees.
- Warrants are dilutive to the equity pool, options are not (because they’re already counted as issued shares, they just haven’t been delivered).
- Warrants are often attached to other securities such bonds, options typically are not.
What’s an example of warrant coverage in action?
Let’s say an investor purchases 1.5M shares in JJR Inc. at a price of $10 per share and asks for 10% warrant coverage as a stipulation of the deal. Their total investment upon the execution of the term sheet is $15M, they also receive $1.5M in warrants. At any point until their warrant coverage matures, they can exercise their right to purchase an additional 150k shares at $10 per share.
Prior to the maturity date, the company has a fair market value of $50 per share and is considering going public. The investor exercises their warrant coverage, purchasing the additional 150k shares—bringing their total investment to $16.5M, and their total holdings to 1.65M shares. By exercising their warrant coverage, they were able to capture an additional $6M in upside appreciation that they otherwise wouldn’t have had without the warrant.
In what funding situations is warrant coverage present?
Warrant coverage can be required by both debt-and-equity financing providers. However, it’s most frequently associated with convertible notes, SAFEs, and venture debt.
What are the elements of a warrant?
- Number of Shares: This outlines the number of shares that the holder of the warrant can purchase if they exercise their warrant coverage on or before the expiry date.
- Strike Price: The predetermined per-share-price the holder pays if they exercise their warrant coverage on or before the expiry date.
- Expiry Date: The date when the warrant needs to be exercised. If it is not exercised it expires and becomes worthless.
What factors play into the valuation of the warrant?
There a variety of factors that play into the valuation of the warrant including:
- Underlying Stock Price: the higher the stock price, the higher the warrant price
- Strike Price: the lower the strike price, the higher the warrant price
- Expiration Date: the longer the term, the higher the warrant price
- Implied Volatility: the higher the implied volatility, the higher the warrant price
- Risk-Free Interest Rate: the higher the interest rate, the higher the warrant price
How would I find out if I have warrant coverage?
Typically warrant coverage would be outlined in your cap table if it was present.
What are the advantages of warrant coverage?
- Fair pricing – the valuation of the warrants is based on the value of equity at the time of issuance.
- Future cash flow – If the warrant coverage is exercised, your company receives the influx of capital from the purchase.
What are the disadvantages of warrant coverage?
- Future potential dilution – If the warrant coverage is exercised, it could result in 1-2% dilution of the current shareholders on average.
- Discounted cash flow from sale of shares — If the current strike price of your shares is higher than the strike price of their warrant coverage, you miss out on the spread.
What are some of the common pitfalls to avoid when agreeing to warrant coverage?
- Using the valuation of a previous round - because the price of warrants is based on the valuation of your company at a specific point in time, using the valuation of a previous round would result in unnecessary dilution and discounted cash inflows.
- Not negotiating the terms - as with most contractual provisions, you can negotiate the terms. While the strike price typically isn’t negotiable, the number of shares and the expiry date usually are.
Our thoughts on warrant coverage?
As with other contractual provisions, warrant coverage serves a purpose. It helps investors reduce their downside dilution risk from future rounds and it helps companies attract more investors, while ensuring maximum participation from committed investors. That said, it’s critical to negotiate the warrant coverage in your term sheet in order to maintain control over your business and eliminate unnecessary dilution.
Looking for non-dilutive funding that’s warrant coverage-free? An Arc Advance can help you extend your runway-and accelerate your growth, learn more here.