Businesses have been able to capitalize on the current low interest-rate environment, and venture debt financing has expanded significantly. Warrants are a typical financial tool frequently used by venture debt providers. Let’s understand warrants in Venture Debt in detail.
What are Warrants?
In venture debt deals, warrants are a common feature. A warrant is similar to an option instrument in that the holder has the right, but not the privilege, to purchase business or company stock at a set price within a particular period for a certain duration. The corporation issues these, which can be described in this manner.
The strike price, also known as the exercise price, is the price at which a warrant holder is legally given the option to buy the company stock. However, this option may only be exercised when this price holds good. Fortunately, the expiration date can be a year to fifteen years at most.
What is the Purpose of using Warrants in Venture Debt Deals?
As with any investment, investors desire profit proportional to the risk they are willing to endure. Some of the many funding options discussed include showing the risk and return related to each. Let’s examine the types of funding and the risks associated with them.
- Banks: Banks are on a risk/return scale; furthermore, they are considered a haven for investment. This is because banks have been investing in transactions that are considered to be ‘less risky ‘. Companies that are larger in size, generate more revenue, are likely profitable, and have more asset-backed coverage are examples of deals that are less risky. They also ensure that businesses maintain stringent requirements, such as debt to EBITDA ratios, and meet interest service and coverage ratios by putting in place financial covenants. To this end, the banks can afford lower interest rates and no warrants, having decreased their risk.
- Venture Debt: Expressing the scale from 0 to 10, I would rate the presence of venture debt lenders at half the scale, as these are the money lenders who provide funds to the rapidly growing companies interested in their further development. These businesses are usually riskier, for while they are in product-market fit and making money, they likely have little or no control over profits anymore (especially if they are a tech or SaaS company), and often, they may not even own tangible assets. Contrary to banks and warrants, lenders of venture loans anticipate and accept a higher risk in return, hence charging higher interest fees.
- Venture Capital: Venture capital is at the king’s absolute high on the risk/return spectrum. These investors experience the highest-risk deals because they fund very early-stage startups. Venture capital investors take a percentage of equity in the hope that the company will be acquired or go public rather than receive interest payments.
What are the Elements of a Warrant?
The key elements of a warrant include:
- Number of shares: A certain quantity of shares will be provided to holders on or before the expiration date
- Strike Price: Warrants can only be exercised at the set price agreed in the contract, which is £0.20
- Expiry Date: The warrant becomes null and void if not exercised by the expiry date.
Average Venture Debt Warrant Coverage Deals
It is common to find venture finance with double-digit interest rates, less restrictive financial covenants, and warrant coverage of 10-20%, as warrants directly result from the risk/return profile the investor is considering. The terms of the stock, interest rate, and venture debt warrant coverage can all be justified based on the risk attached to the transaction.
For the founders, warrants are usually limited to only 1-2 % of the business, provided they are implemented. This is provided the venture debt lender cares to exercise them, and it is greatly less than the dilution associated with venture capital funding. They will sometimes still be obliged to buy those shares, even if they decide to exercise their warrants.
Example:
Company B gets a $3 million loan from a venture debt lender with a 10% coverage warrant. Company B offers the lender a warrant in which $300,000 worth of shares in the B company will be sold for 5 years.
The lender’s current position is a warrant with the ability to exercise the right to commit $300,000 to purchase shares in Company B at the price of the latest financing by Company B on or before the expiration date.
Advantages of Warrants
There are multiple advantages of warrants for both the corporation and the lender.
Regarding Lenders
- Allows greater participation in the enlargement of the business and potential revenues
- That is, technically, there is rarely any upfront fee; payment is made only if and when the lender decides to exercise the warrants.
Regarding the business
- Fair pricing: Warrants are normally issued at the current market value of the underlying equity.
- Future cash flow: If the lender exercises the warrants, they must purchase the shares.
Drawbacks of Warrants
Warrants have many advantages, but they also have drawbacks for lenders and businesses.
Regarding Lenders
- Finite life: Warrants have a finite life and must be used by the expiration date at the latest.
- Fall to zero: If a warrant is exercised, its value could drop to zero, resulting in a loss equal to the whole cost of the investment.
- No control rights: The control rights granted to shareholders do not extend to warrant holders.
- No dividends: As warrant holders are not entitled to dividend payments, they do not receive dividends.
Regarding Businesses
- Future potential dilution: If the warrant holder chooses to exercise their warrants, there may be a 1% to 2% dilution.
- A portion of the shares is acquired at a bargain if the equity value is greater than the strike price at the time they are exercised.
How are Warrants Priced?
The predetermined price at which warrants can be purchased is known as the strike price. Generally speaking, the strike price is the same as the company’s stock’s fair market value on the day the warrant is granted. The striking price can be ascertained in three different ways:
- Utilize the valuation from a recent equity round – Assume that Company A has recently concluded its Series A funding round. $20 million was given to the corporation, valued at $100 million. To determine the striking price, warrants would be valued at the $100 million equity valuation.
- Agree to a negotiated valuation – Without a recent equity round, a negotiated valuation can be agreed upon between the lender and the business. Company A has opted to raise venture debt rather than a Series A investment to reduce dilution. Company A and Lender B can collaborate to determine a fair valuation because there hasn’t been a recent round of equity and, thus, no current company valuation.
- Apply a discount for a future raise – The final strategy is pricing at a discount to a potential future equity offering. Although Company A is closing their venture debt deal this month, they know they will raise a Series A in six months. By setting the strike price of the warrants, Company A and Lender B will agree to place it at 20% below the equity value of the forthcoming Series-A round. For example, if Company A is being valued at $100 million during its Series-A round, the associated equity value for these warrants would be $80 million.
Understanding the Importance of Warrants in Venture Debt
In this article, we have covered everything in detail about the importance of warrants in venture debt, such as the types of funding and risk associated with it, the advantages and disadvantages of warrants, and so on. Understanding warrants in venture debt is crucial because they provide lenders with equity upside potential, aligning their interests with the company’s growth and mitigating risk. This balance makes venture debt an attractive financing option for startups.
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