A convertible note warrant is a good method for incentivizing investors, as it gives them the right to purchase a certain amount of company shares at a later date.

What Are Convertible Note Warrants

Issuing a warrant is a good solution for attracting investors to your company. The drawback of convertible note warrants, however, is that they can usually only be used if your company has already raised equity. Warrants can also be very complex. If your company is still in the seed round of financing, you should not use warrants, as they may cause legal issues.

You can use a warrant if your investor insists or your company is in a convertible debt round of financing. Imagine that an investor is putting $200,000 into your company and that they insist on warrant coverage. Assume that coverage is for 20 percent of the investment. This means that your investors convertible note warrant would be for $40,000.

At this point, you might wonder what this amount of warrant coverage means in reality. Basically, your investor's warrant gives them the ability to purchase shares in your company at a set price.

Using the above example of a $40,000 warrant, there are several ways to determine how much stock the investor would be able to purchase:

  • The investor could purchase $40,000 of common stock based on the most recent value of preferred or common stock.
  • The investor could buy $40,000 of preferred stock at the value determined in the last round.
  • The investor may purchase $40,000 of stock in the next round at that round's value.

When issuing warrants, it's important to consider what percentage of your company the warrant will represent. The security underlying the warrant will determine this percentage. You should also consider if your company will be issuing certain classes of stock. For instance, if a warrant entitles an investor to purchase voting class stock, it means they will have much more power in your company and can determine the outcome of important company votes.

Warrant Terms to Understand

If your company is thinking about providing warrants to investors, there are several warrant terms that you should be sure to understand. Term length is the first warrant term that you need to know. Term length refers to how long the investor has to exercise the warrant. The typical term length for a warrant is between five and 10 years. Companies will generally prefer a shorter term length, and investors want the term length to be longer so that they have more time to exercise their rights and maximize their return on investment.

Another warrant term that you need to know is merger considerations, which means what happens to the investor's rights if the company is eventually sold. When writing a convertible note warrant, it is crucial that you include language that states the warrant will expire when a merger occurs.

If a merger is planned, the investor holding the warrant will need to decide if the will exercise their rights before the merger is completed and the warrant expires. Setting warrants to expire upon a merger is important because an acquiring company may not want to complete the purchase if there are outstanding warrants that will remain in place after the sale.

Warrants can easily delay the sale of a company, and the acquiring entity may demand that the original company purchase or renegotiate the warrants as part of closing. Original issue discount is a warrant term that refers to accounting. Essentially, to avoid this discount, you will need to be sure that warrants are paid for separately in a convertible debt deal.

For instance, if the convertible note is for $200,000 and there is a 20 percent warrant, then the warrant possesses value according to the Internal Revenue Service (IRS). If the debt deal does not include a provision related to purchasing the warrants, then the $200,000 given to the company by a lender is considered discounted, since the lender was giving warrants without paying for them. This means that when your company repays the $200,000, you will also have to pay interest. Having a lender pay you a nominal amount for the warrants will help to prevent this issue.

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