Warrants: What They Are and Why They’re Risky

warrantA warrant (also called an equity kicker) is a security that grants a lender the right to buy stock in a company for a fixed price until a preset expiration date. Warrants are typically provided as an incentive to investors in exchange for their investment; however, depending on the lender, they may also be a loan condition required as part of a venture debt agreement. Regardless of how they come about, they must be issued by the borrower if used.

Warrants are expressed in the form of coverage — a percentage of the lender’s investment in your business usually in the range of five to 10 percent. On a $500,000 loan, you may be required to provide warrant coverage of 10 percent. This means you would provide the lender with a warrant that gives them the right to purchase $50,000 of your company’s stock.

While a warrant may appear as a low-risk solution for accessing working capital (and when you compare it with the upfront equity requirement of VC and the implications of it, a warrant is reasonably low risk), there are still some factors that must be taken into consideration before finalizing the deal.

You’re Giving Up the Security of Complete Ownership

One of the strategic advantages of venture debt financing is that lenders don’t take an ownership position in your company — i.e., they don’t own any equity or occupy a board seat. Whereas venture capital investors, angel investors, and banks may require an equity stake, debt financing lenders allow you to retain control of your organization.

This is a significant benefit in that you as a SaaS founder or owner can do what you want, when you want, and how you want. You can make high-level decisions, spend capital how you want, hire who you want for key roles, and so on — without having to consider the stance and requests of an outside investor that’s occupying a seat on your board.

But when you provide or accept the requirement of a warrant, the door for a lender to take ownership — at their discretion — is wide open. You’re giving a debt lender who otherwise wouldn’t hold an ownership position in your business the legal right to take ownership in the future — with the added benefit of earning interest on their investment.

A caveat is that the lender has a time limit for deciding what to do with the warrant. While it’s not a short time frame (typically five to seven years), there will always be the knowledge that the investor could at any time exercise the warrant to gain ownership. You haven’t completely lost control…but you’ve lost control over having complete control.

If the investor decides to exercise the warrant within the time period, they will own a portion of your company. If you already have VC investment, some lenders may use warrants to gain rights to invest in your future equity round on the same terms, conditions, and pricing offered to investors at that time.

The Value of Your Shares Might Change

Warrants provide the lender with the right to buy stock at a fixed price — typically at the figure established during your most recent funding round. If there hasn’t been a funding round recently or at all, then the warrant price can be negotiated.

As you move forward using the working capital provided, your stock will grow in value, lose value, or stay flat. If your stock continually increases in value during the warrant time frame, the lender will hang on to the stock because it will be more valuable toward the end of the time limit. And when the time comes for the lender to exercise the warrant, they’ll be entitled to purchase more of your stock for a lower price than anyone else would be able to.

If you exit at some point, a lender would certainly exercise the warrant at that time. And if your stock begins to lose value, they will assuredly exercise the warrant because it guaranteed them a certain price for it, regardless of where the stock stands at excision.

A final consideration is that warrants dilute existing stock. Should the lender exercise the warrant, your company would provide them with new stock rather than existing stock. Whereas your shares would lower in value, the investor’s shares protected by the warrant terms have the same value as when the warrant was issued.

Long-Term Incentive…or Long-Term Risk?

Warrants are a useful mechanism for convincing and rewarding a lender to invest in your SaaS business. But remember, they’re effectively turning a non-VC investment into something very similar. It’s up to you if you’re willing to take the risk. At River SaaS Capital, we don’t take warrants for our loans — ever. Many other venture debt lenders do. That’s why you owe it to your business and employees (some of whom may be shareholders) to explore your options.

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