What is a Warrant?

You are reviewing a term sheet for venture debt or a bridge loan and you see a clause asking for warrant coverage. It sounds technical and perhaps a bit intimidating.

At its core, a warrant is a security that gives the holder the right to purchase company stock at a specific price within a specific timeframe. It is not an obligation to buy. It is simply the option to do so.

Founders often confuse warrants with standard stock options because they function similarly mechanically. However, the use case and the legal structure differ in important ways that impact your capitalization table.

When a startup issues a warrant, they are issuing a contract directly from the company to an investor or partner. This contract outlines three main components.

The exercise price is the fixed cost per share the holder must pay to buy the stock. This is also called the strike price.

The expiration date is the deadline by which the holder must exercise their right to buy the stock.

The number of shares indicates exactly how much equity the warrant converts into.

If the value of your company grows significantly, the stock price will rise above the exercise price. The warrant holder can then buy shares at the lower fixed price and instantly realize a gain. If the company value drops below the exercise price, the warrants are worthless and will likely expire unused.

It is vital to distinguish between these two instruments to avoid confusion during board meetings or negotiations.

Stock options are typically reserved for employees, advisors, and consultants. They usually come from an option pool that has already been set aside. The goal is incentivizing talent.

Warrants are typically used for investment transactions or commercial deals. They are issued to third parties like banks, venture capital firms, or corporate partners. The goal is sweetening a financial deal.

There is also a difference in dilution.

• When an employee exercises a stock option, they are often using shares already accounted for in the option pool.
• When an investor exercises a warrant, the company creates new stock to fulfill the request.

This means warrants create new shares and dilute existing shareholders differently than the standard employee pool.

Startups encounter warrants in a few specific scenarios. It helps to know these contexts so you can anticipate when an investor might ask for them.

Venture Debt This is the most common scenario. Lenders offer loans to startups but want upside potential if the company exits for a large amount. They ask for warrant coverage to offset the risk of lending to a high growth business.

Bridge Rounds If you are raising money between major priced rounds, early investors might ask for warrants as a reward for providing capital at a risky moment.

Partnerships Sometimes a large corporate partner will integrate your technology but requires warrants to ensure they benefit if your company grows due to their distribution.

While the math is straightforward, the strategic implications remain complex. We often do not know the future valuation of the company, which makes pricing warrants difficult.

Are you giving away too much future upside for a small amount of capital today? Is the exercise price set based on the last round or a discount to the next round?

Keep these variables in mind. Warrants are powerful tools to close deals, but they represent real ownership in your business.