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 stock 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 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 stock 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 warrant can be worth a lot of money to the lender.
A warrant works similar to an incentive stock option for employees. Stock 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.
With interest rates for venture debt historically around 10 to 15%, venture debt lenders offset those relatively low interest rates for riskier borrowers — often early-stage tech startups — by adding warrant coverage.
Warrant coverage on venture debt deals
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 loans with warrants.
Are debt warrants good for startups?
In a word, no. Warrants are risky for founders, which can greatly increase the true cost of capital sourced from venture debt deals. Here are the three main problems with startup warrants:
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 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 cash flow and operations.
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Why do venture debt deals require warrants?
Venture debt lenders, specifically, like to use debt 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 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.
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 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 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.
Debt Warrant 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.
Do all startup loans require warrants?
No, not all startup loans come with warrants in their agreement terms. Look for established lenders who assume far less risk across their portfolios compared to venture firms — they will offer startup debt financing solutions without warrants.
Lighter Capital's approach to financing
Our startup financing solutions are straightforward and non-dilutive for a reason: We pride ourselves on founder-friendly lending that's faster, easier, simpler, and more transparent than other options.
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 your short and long-term goals. We work with startups in our "sweet-spot" for growth, which not only minimizes our risk as a lender, but also eliminates any need to dilute your equity. Best of all, 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 with any of our loans. Warrants are complex, inconvenient, and require giving up ownership.
At Lighter Capital, we focus on helping young startups grow without taking away their valuable equity. Check out our non-dilutive debt financing solutions that can give you the runway you need to create new paths 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 mindful of when they dilute.
When venture lenders take stock warrants and your startup then has an exit, they will walk away with a small portion of equity in your business with huge upside.
See what equity dilution might cost you. Try our dilution calculator ➔
Therefore, it’s a good strategy to dilute equity as late in the game as possible, and these days, there are plenty of non-dilutive growth capital options that can help you delay equity dilution in your early stages.
Waiting to accept stock 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 startup 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.