What is Warrant Coverage?

Warrant coverage is a term that often surfaces when a startup begins looking for capital outside of traditional equity rounds. It is most commonly associated with venture debt or bridge loans.

At its core, warrant coverage represents the percentage of the loan principal that the lender can convert into equity. It acts as a sweetener for the deal. The lender gets their interest payments and repayment of the principal, but they also get a small piece of the potential upside if your company succeeds.

This mechanism allows lenders to justify taking risks on early-stage companies that might not have significant assets to collateralize a loan.

Founders often get confused by how the percentage is applied. The warrant coverage percentage is not the percentage of your company you are giving away. Instead, it is a percentage of the dollar amount of the loan.

Here is a simplified example.

Imagine you secure a venture debt deal for $1,000,000.

The term sheet specifies 10% warrant coverage.

This means you are granting the lender warrants with a total value of $100,000 (10% of $1 million).

To determine exactly how many shares that equals, you divide that $100,000 value by the price per share of your most recent equity round or a negotiated strike price.

If your most recent preferred stock price was $1.00 per share, the lender receives 100,000 warrants. These warrants give them the right to buy those shares at that set price for a specific period, usually ranging from seven to ten years.

Venture lenders are not venture capitalists. They do not operate on a power law model where one massive winner pays for ninety-nine failures. Lenders need the majority of their loans to be repaid to stay in business.

However, lending to startups is inherently risky.

Warrant coverage helps balance the risk and reward equation. It allows the lender to offer a lower interest rate on the cash because they have the potential for a return on equity later.

If your company exits or goes public, those warrants could be worth significantly more than the interest payments. If the company fails, the warrants are worthless, but the lender ideally recouped their principal through the loan structure.

When evaluating a term sheet with warrant coverage, you must view it as part of the total cost of capital.

A loan with a 12% interest rate and 0% warrant coverage might seem expensive compared to a loan with 8% interest and 20% warrant coverage. However, if your company valuation triples in two years, that 20% coverage becomes very expensive equity dilution.

Founders must calculate the Internal Rate of Return (IRR) for the lender to understand what the loan actually costs under different exit scenarios.

There are specific times when accepting higher warrant coverage makes sense.

Perhaps you need to extend your runway to reach a major milestone before raising a Series A. The dilution from the warrants might be significantly less than the dilution you would suffer by raising an equity round too early at a lower valuation.

Is the immediate cash roughly worth the future equity? This is the question you must answer before signing.