Lighter Capital: Faster, lighter-weight, simpler, easier, more transparent… the list goes on.
But wait, if that’s all true, then what’s up with the warrants?
This question comes up frequently when discussing loan terms with entrepreneurs. Yes, it’s true, while we are faster, simpler and easier than other funding sources such as private equity or bank loans, we do require as a part of our loan package the somewhat discommodious “Warrant Coverage”.
First, the definition: “An agreement between a company and its shareholders whereby the company issues warrants equal to some percentage of the dollar amount of the shareholder's investment… This would not give the investor any additional downside protection as the underlying shares would be issued at the same price that is currently paid for the stock. However, the warrant coverage would give the investor additional upside in the event that the company goes public or is sold at a price above [the strike price].” This definition refers to an equity investment, but you get the idea.
Secondly, why do we require warrant coverage?
We require warrant coverage for two reasons:
1) “Schmuck insurance”. While we are lenders, we employ a model that is not as simple as burning-and-turning mortgages. We lend high-risk growth capital, and, as such, analyze investment opportunities thoroughly. If we find and fund the next “Facepon: Facebook-Meets-Groupon” to its $5 billion IPO, and all we got was our 20% IRR, we look like schmuck investors.
2) Portfolio Theory. As mentioned, we lend high-risk capital. Banks lend low-risk capital. Arguably, today they lend no-risk capital (if any at-all), or sometimes do even better: get collateral without even making loans!. A bank’s default risk is quite low (or zero, when they require a personal guaranty ON TOP of SBA (ahem, taxpayer) backing). A bank’s corporate credit portfolio generally performs well enough to offset any loan losses, operating expenses and still return some profit. In contrast, however, our loan profile is more volatile, with a higher possible default rate. To help offset this higher default rate, we introduce warrants. The small amount of warrant coverage we hold in one (your company), two or three companies that do have huge exits will counter-balance the more frequent defaults (not your company) we may experience.
Warrant coverage can be a complex thing and may seem counter-intuitive to our light-weight and non-dilutive mantra.
The take-aways are: 1) it’s not just your company-- we require it of all our investments; 2) if you don’t have a liquidity event within a reasonable time horizon (5 years from the termination date of the loan), then they expire, worthless and there’s no other cost, expense or liability to you – they just evaporate; and 3) in the event that you do have a liquidity event, it is true that they are slightly dilutive, but their value is generally quite small relative to total firm value.
Plus, that means you built (and we helped fund) the next “Facepon”; you look like a hero, and we…. at least don’t look like schmucks.