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, stock warrants, debt covenants, and even whether we require a personal guarantee. We covered the latter two concerns in other posts, linked above.
In this article, we give you answers and explanations to frequently asked questions about warrants, which are commonly encountered in venture debt deals, including:
What is a stock warrant?
How do warrants work?
Do all startup loans come with warrants?
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 stock warrant?
A stock warrant is an agreement in which a lender has a right to buy equity in the future at a price established when the warrant was issued or in the next round.
For example, the right to buy $X dollars worth of shares in your company (usually calculated as 1-5% of the loan).
Many venture debt lenders require warrants and expect roughly half of their total returns will come from warrants (and half from interest payments). If your startup does well, the stock warrant can be worth a lot of money to the lender.
A stock warrant works similar to an incentive stock option for employees. Warrants have the potential to make the holder a large profit very quickly if the price of the company’s stock is much higher than the price at which the warrant holder is permitted to buy it.
Why are warrants risky for startups?
There are three main problems with stock warrants:
Stock warrants dilute your ownership, so do the math on how much any warrant will cost you, assuming you meet your projections.
Stock warrants align interests between the lender and a startup in good times, but they don’t align interests if your startup doesn’t grow as quickly as you want.
Many lenders require a “put option,” which gives the lender the right to sell the warrant back to the company 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 cashflow and operations.
Why does venture debt require warrants?
Venture debt lenders like to use stock warrants to reserve the right to share in potential profits when a borrower company 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 their return. The stock warrant coverage the venture lender holds in the few companies that do have huge exits counter-balances the more frequent and larger defaults some of their other borrowers experience.
Stock warrants provide upside protection only in venture debt deals; 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 also gets to benefit from the company’s success.
This high upside potential — along with high risk — is why venture debt deals often feature stock warrants as part of their “risk capital” structure.
How do stock 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.
Stock warrant example: Roku
Here’s a real-life example of how stock 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.