What Are Debt Warrants and Are They Good For Startups?
- Lighter Capital
- Jan 4, 2024
- 6 min read
Updated: Sep 10
At Lighter Capital, our Investment Team encounters a lot of questions from startup founders about the features of our financing solutions, such as early payoff provisions, minimum return requirements, warrants, debt covenants, and even whether we require a personal guarantee.
In this article, we give you answers and explanations to frequently asked questions about debt warrants, which startup founders regularly encounter when fundraising, including:
Ready to arm yourself with knowledge that will help you make the best financing decisions to keep growing a healthy business? Let's dive in.
What is a Debt Warrant?
Used in both debt and equity financing, a warrant is an agreement in which a startup capital provider has a right to buy company stock in the future at a price established when the warrant is issued or in the next funding round.
Many venture debt lenders require warrants and expect roughly half of their total returns will come from warrants (and the other half from interest payments). If your startup does well, the lender's warrant can be worth a lot of money.
A warrant is similar to an incentive stock option for employees. The warrant holder makes a large profit if the price of the startup’s stock is much higher than the price at which the warrant is exercised. More of how warrants work, shortly.
With interest rates for venture debt historically around 10 to 15%, lenders offset those relatively low interest rates for riskier borrowers—often early-stage tech startups—by adding warrant coverage.
Warrants and Venture Debt
In venture debt deals, warrant coverage refers to the contractual agreement between a startup and the investor, which details the amount of shares the investor can purchase—expressed as some percentage of the amount of capital they invested—and the predetermined price at which they can purchase the shares by some date in the future.
Warrant coverage on average can range from 10 to 20% in venture debt deals. The predetermined price, also called the strike or exercise price, is only valid for a limited time period, which can range anywhere from 1 to 15 years.
The strike price is typically set by the company's fair market value (FMV) the day the warrant is issued. This is determined one of three ways:
Using the the startup's valuation at its most recent equity funding round.
Agreement on a negotiated valuation (usually when there has been no recent company valuation).
Price at a discount to a future equity raise; for example, X% below the equity value at the upcoming round.
All of this is might be expressed with a phrase like 10% warrant coverage. That means the lender receives $X in warrants, in which X is 10% of the loan principle.
Yes, there is some information missing—you'll need to understand the strike price and the expiration date to truly evaluate the deal terms if you're considering debt funding with warrants.
Why does venture debt require warrants?
Venture debt lenders, specifically, like to use warrants to reserve the right to share in potential profits when a startup makes it big. If the lender funds the next unicorn to a $5 billion IPO, the lender wants to get more out of the investment than just their return on the debt.
Venture debt providers often require warrants to counter-balance risky investments in their portfolios that often don't pan out. If a few of the lender's portfolio companies do well and have big exits, the upside from warrants offset other losses. Warrants are a calculated part of their "risk capital" structure.
Debt warrants provide investors upside protection only; they do not offer downside protection. So if a company tanks, having warrants doesn’t help the venture lender prevent or recoup losses. However, if a company goes public in a spectacular fashion, the venture lender get additional benefits from the company’s success.
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How Do Debt Warrants Work?
To use a stock warrant when a company has a liquidity event, like an IPO, a venture lender waits for the price of each share to rise above a set minimum price, called the strike price.
For example, if a company’s stock sells at $20 a share upon the IPO, but the venture lender’s warrant has a strike price of $25/share, the lender will purchase the stock only when it rises above $25/share. In many cases, the stock will immediately start selling above the warrant’s strike price. If the value of the stock never rises above the strike price, then the warrant becomes worthless.
Example: Roku
Here’s a real-life example of how debt warrants work. When Roku had its IPO in 2017, a venture lender had a warrant for 400,000 shares of Roku’s preferred stock with a strike price of $9.17340.
On its first day of trading, Roku started with a share price of $15.78 — already above the venture lender’s strike price. The lender paid $9.17340 for each of the 400,000 Roku shares on which it wanted to exercise the equity warrant, paying a total of $3,669,360.
In this scenario, the warrant was worth $2.6M net (or $6.6066 per share) at no marginal cost to the lender. Had the warrant not been there, that money would have gone to the owners, founders, and equity investors, instead of the venture lender.
If a company doesn’t have a liquidity event within a reasonable time—usually five years from the end date of the loan—then a debt warrant usually expires. The lender loses the ability to act on them, and thus they are no longer a liability to the issuing company.
Are debt warrants good for startups?
Warrants can be risky for founders, particularly in early-stage deals; warrants when exercised will increase the true cost of capital sourced from venture debt.
Here are the three things to consider before agreeing to debt with a warrant:
Warrants dilute founder equity, so do the math on how much any warrant will cost you, assuming you meet your financial projections.
Warrants align interests between the lender and a startup in good times, but founders can feel pressured and stressed when the startup doesn’t grow as quickly as investors expect.
Many lenders require a put option, which gives them the right to sell the warrant back to the startup after a certain number of years. You have to assume you’ll be required to make this payment, which can easily be enough to disrupt your startup’s cash flow and operations.
How much will equity dilution cost you?
Compare dilutive and non-dilutive funding with our equity dilution calculator.
Does All Startup Debt Require Warrants?
No, not all startup debt comes with warrants in their agreement terms. Established lenders who assume far less risk across their portfolios, compared to venture firms, will offer non-dilutive debt financing solutions without warrants.
Truly non-dilutive debt for startups
Lighter Capital's startup financing solutions are straightforward and non-dilutive for a reason: We strive to provide the most founder-friendly funding that's faster, easier, simpler, and more transparent than other options.
The entire Lighter team is focused on helping young startups grow. We aim to build lasting relationships on a foundation of trust—that starts with ensuring our expertise is complementary and we can provide funding that aligns with founders' short and long-term goals.
We work with growing tech startups in our sweet-spot, which not only minimizes our risk as a lender, but also eliminates the need to dilute your equity. Best of all, when you partner with Lighter Capital, you and your founding team remain entirely in control of the business you've worked so hard to build.
True to our ethos, we rarely ask for warrants on loans. Warrants are complex, inconvenient, and require giving up ownership, which isn't ideal for early-stage startups.
Learn more about our financing solutions that can give you the runway you need to forge a path to a lucrative and successful exit.
When should a startup consider warrants?
It's not that founders should never dilute or that dilution has no place in early-stage startup funding; it's that founders need to be more mindful of when they dilute.
When venture lenders take warrants and your startup then has an exit, they walk away with a small portion of equity in your business with huge upside.
Generally, it’s a good strategy to dilute your equity as late in the game as possible, and these days, there are plenty of non-dilutive capital options that can help you delay equity dilution in your early stages—when giving up equity is most costly.
Waiting to accept warrants once your business is further along gives you more leverage you can bring into future negotiations with venture capital investors, which can help you increase your valuation. And with a higher valuation, warrants will account for a smaller a percentage of the company on a pro rata basis.
Learn more about debt financing for startups
We revolutionized the startup finance playbook with our non-dilutive founder-friendly funding solutions.
Download Financing Your SaaS Startup Using Debt: Choosing The Right Type of Debt financing for Sustainable Growth to learn more about the debt financing solutions for startups, including what you should watch out for, how to compare offers with different terms, and more.
