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 previously covered the latter two concerns, but you may still be wondering, what is a stock warrant? How do warrants work? And does Lighter Capital require them for our financing? These are all excellent questions that we’ll clear up, ensuring you’re armed with the right knowledge to make the best loan decision for your business.
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.
What’s the risk concern with stock warrants?
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.” This 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 be very large and hinder your startup’s ability to grow.
Why do venture lenders require warrants?
Venture 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 give venture lenders upside protection only; they don’t provide any 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 lenders often use stock warrants as part of their “risk capital” structure.
How do 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 of how stock warrants work
Here’s a real-life example: 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 stock 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. This would have been upside to the owners, founders, and equity investors had the warrant not been there (that’s money to the lender and out of the other parties’ pockets).
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 stock warrant usually expires. The lender loses the ability to act on them, and thus they are no longer a liability to the issuing company.
Lighter Capital’s approach to lending
Our approach to lending is light-weight and non-dilutive for a reason. We pride ourselves on lending in ways that are faster, easier, simpler, and more transparent than others. The relationships we form are all built around the idea that with the right expertise, companies can be evaluated thoroughly and funded properly with minimal risk, allowing founders to remain entirely in control of the companies they’ve built and without diluting their ownership in any way whatsoever.
As part of this approach, we don’t require stock warrants from any of our borrowers. Stock warrants tend to be complex, inconvenient, and require giving up ownership — they don’t fit our approach.
Why we don’t require stock warrants
Since we lend high-risk growth capital at Lighter Capital, we work with companies that have the potential to make it very big. Yet the essential way our funding model differs from equity financing is that we don’t acquire a share of the company upon lending, as venture lenders typically do. We’re focused on leaving all the upside to the entrepreneur.
We eschew stock warrants, not because we believe founders should never dilute or that dilution has no place in early-stage startup funding, but because we believe founders should simply be mindful of when they dilute. When venture lenders take stock warrants, should your startup have an exit, they will walk away with a small portion of equity in your business with huge upside. It’s a good idea to dilute as late as possible after exploring alternative, non-dilutive funding to fuel growth in early stages.
Waiting to accept stock warrants allows founders to continue raising their valuation in order to have more leverage in eventual negotiations with venture capital investors. The higher a company’s valuation, the smaller a percentage of the company on a pro rata basis warrants will account for.
Lighter Capital’s focus is on helping early stage startups grow without giving away equity in the company that the founder and staff have so carefully built. Our goal is to get startups to a stage at which they have more options, whether that means proactively deciding to grow organically using alternative funding or taking on private equity at a high valuation to accelerate growth. We prefer not to use warrants as we play this role so our funding can remain truly non-dilutive.
At Lighter Capital, we’re revolutionizing the business of startup finance – we don’t require stock warrants to qualify for financing. Download our free Alternative Finance Industry Report in which we explore the changing landscape of tech startup financing, analyzing why founders are turning to debt capital options like revenue-based financing to fuel growth.
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