An important part of scaling for start-ups and emerging companies requires strategic use of investment tools. Stock options and warrants, while similar, are distinct forms of equity structures that are often confused. This article is part of our series discussing these strategies in turn and exploring key considerations that start-ups and emerging companies should be considering when issuing either. For further information about stock options, see our article “Stocked up: How start-ups and emerging companies can effectively utilize options to attract and retain talent.”
There has been a significant uptick in the number of start-ups and emerging companies using warrants to close the gap on various transactions. When offered in conjunction with effective negotiation, warrants can incentivize third parties to enter transactions or to agree to more favorable deal terms.
A warrant is an agreement between a company (the “Issuer”) and the holder of the warrant (the “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 shares of the company 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 incentivize investors to invest or to incentivize 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 enter into the transaction or buy into the company’s long-term success.
Although warrants are similar in structure and serve a similar function to options, the critical difference is that options are typically issued to internal stakeholders, such as employees, directors, consultants and other service providers, and not to external third parties. Further, as options are typically issued under an option plan, the issuance of these options would need to conform to the terms of that plan. On the other hand, warrants are typically offered to external third parties as described above.
The issuance of a warrant is usually evidenced by way of a document called a warrant certificate. A warrant certificate sets out the essential terms of the warrant, including:
- 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 when Issuing Warrants
Types of Shares
Before issuing warrants, start-ups and emerging 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 be entitled to preferred shares. When issued to investors as a “sweetener,” the underlying security will typically match the shares purchased by the investor. For example, outside investors, such as venture capital funds, 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 formulaic approach to calculating the number of shares the Warrantholder may acquire can be a valuable tool to incentivize a third party, such as where the Warrantholder is a strategic sales channel partner. Therefore, the warrant could be structured so that the sales channel partner would have the right to purchase additional shares if the sales channel partner meets specific sales targets. In addition, a formulaic approach may also incentivize 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. However, when using a formulaic approach or fixed percentage warrants, start-ups and emerging companies must carefully consider the dilutive effects of any mechanisms that allow for an increase in the number of shares a Warrantholder may acquire.
Alternatively, 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 warrant generally does not require price-protection anti-dilution provisions (discussed below). As the number of shares the Warrantholder can purchase is calculated at the time of exercise, fixed percentage warrants can disproportionately impact other shareholders of the company, including its founders, if the company issues additional shares prior to exercise by the Warrantholder of the fixed percentage warrant. Any start-ups and emerging companies that are considering issuing fixed percentage warrants should determine whether there will be any inadvertent consequences of doing so and should consider if fixed percentage warrants should expire prior to a specific event, such as the company’s next round of financing.
The exercise price (the “Strike Price”) of a warrant is the price of each share underlying the warrant. The Strike Price of a warrant can vary dramatically depending on the context in which the warrant will be issued. In certain circumstances, companies will set the Strike Price at or above the fair market value of the underlying securities. In other circumstances, the Strike Price will be set at a nominal value, which are typically called “penny warrants.” The Strike Price could also be calculated based on a predetermined formula or based on the future valuation of the start-up or emerging company.
The warrant may be subject to anti-dilution provisions, which are intended to protect the Warrantholder’s right to receive the value that was negotiated at the time of issuance of the warrant. Certain corporate actions taken by the Issuer during the term of the warrant may have a dilutive effect on the value of the underlying securities, such as consolidation of the company’s outstanding shares or distribution to shareholders of additional shares by way of dividend. A down round may also trigger price-protective anti-dilution provisions—this occurs where the company issues shares at a lower price per share than had been sold in a prior round. For price-protective anti-dilution provisions, the formula used to determine the manner in which the warrants will be adjusted is often a negotiation point.
Start-ups and emerging companies must carefully consider how a down-round will impact the warrant terms. Anti-dilution provisions may adjust the Strike Price and/or the number of underlying shares that are exercisable. The adjustment should be proportionate and reflective of the triggering event and place the Warrantholder in substantially the same position but for the triggering event. Both the Warrantholder and the emerging company must carefully consider how any anti-dilution provisions are drafted. This includes ensuring that there are appropriate carve-outs for predetermined events—such as equity issued as compensation—that do not inadvertently trigger the anti-dilution provisions.
Warrants are exercisable up until a specific time, often referred to as the expiration date or maturity date. The term will depend on many factors, including the nature of the deal. Generally, a longer term increases the value of the warrant because there is a greater likelihood of the company’s success over time and, therefore, a more significant payout as the shares appreciate.
The term may be subject to adjustment provisions if certain fundamental changes are undertaken by the Issuer during the term of the warrant. For example, triggering events for term adjustment provisions may include an amalgamation, merger or disposition of the Issuer’s assets. In the case of these events, the term of the warrant may accelerate so that each outstanding warrant will, after the completion of such an event, be exercisable for the kind and amount of shares that the Warrantholder would have otherwise been entitled to receive immediately prior to the effective date of the event.
When determining the term of the warrant, start-ups and emerging companies must do so in the context of their growth strategy. As discussed above, the type of warrant and its terms may also need to be considered when establishing the expiration date of any warrant.
Exercise of Warrants
Most warrants will be freely exercisable in whole or in part by paying the cash exercise price. Some warrants also allow for what is called 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.
If used correctly, warrants can be a useful tool to incentivize investors and secure critical relationships with customers, buyers, sellers, and partnerships. However, start-ups and emerging companies must carefully consider the warrant terms to ensure they effectively support their long-term growth.