Key Takeaways

  • Convertible warrants allow investors to purchase equity at a future date and price, offering upside potential with lower upfront risk.
  • Warrant coverage is often expressed as a percentage of the investment and can affect ownership dilution.
  • Key terms like term length, conversion price, and merger considerations shape the value and complexity of a convertible warrant.
  • Warrants can enhance fundraising efforts, especially when structured to avoid pitfalls like IRS discounts.
  • Regulatory oversight, such as by the SEC, ensures transparency and investor protection in these financial instruments.

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.

How Warrant Coverage Works

Warrant coverage refers to the amount of equity exposure an investor receives through warrants relative to their investment. For example, a 20% warrant coverage on a $500,000 convertible note would entitle the investor to $100,000 worth of equity at a predetermined strike price. This strike price is often aligned with the valuation in the next priced equity round or another agreed benchmark.

Warrant coverage can vary depending on the investor's negotiating leverage, the risk profile of the business, and the stage of funding. High warrant coverage may signal that the investment carries substantial risk or that the company is offering added incentives to attract investors. Founders must also be cautious of excessive dilution and consider whether warrant holders will receive common or preferred stock.

Convertible Warrants vs. Convertible Notes

Convertible warrants and convertible notes are distinct financial instruments often used together in startup financing. A convertible note is a debt instrument that converts into equity upon a triggering event, such as a priced equity round. In contrast, a convertible warrant gives the holder the option—not obligation—to purchase equity at a specific price, typically without a maturity date.

While notes carry the risk of default if not converted or repaid, warrants pose no repayment obligation but offer investors upside potential if the company’s valuation increases. In a single investment deal, convertible notes may include warrants as an additional sweetener for early-stage investors. Understanding the interplay between these two tools is crucial for founders navigating venture financing.

Risks and Regulatory Considerations

Convertible warrants, like other hybrid instruments, carry risks that both issuers and investors must consider. These include:

  • Dilution Risk: Founders may lose significant ownership if a large number of warrants are exercised.
  • Complex Terms: Warrants often involve layered legal provisions that may complicate future financing or exits.
  • Market Conditions: If the company’s stock value does not exceed the exercise price, the warrant may expire worthless.
  • Regulatory Oversight: In the U.S., convertible securities (including warrants) are subject to SEC rules, which mandate disclosures to protect investors and promote transparency.

It’s important to ensure that the terms of the warrant do not unintentionally breach securities laws or create valuation issues, especially during follow-on rounds or mergers.

Strategic Use of Convertible Warrants by Founders and Promoters

Convertible warrants are not only used for external investor incentives—they are also a strategic tool for founders and promoters. Promoters might issue themselves convertible warrants as a way to inject funds into the company while preserving the flexibility to convert into equity later at favorable terms.

This practice must be handled carefully to avoid conflicts of interest or market manipulation perceptions. Regulatory bodies often scrutinize such transactions to ensure fairness to minority shareholders and transparency in financial reporting. Promoters should document the rationale behind warrant issuance and secure shareholder or board approvals where required.

Frequently Asked Questions

1. What is the difference between a convertible warrant and a regular warrant? A regular warrant grants the right to buy equity at a future date, while a convertible warrant may include terms that allow conversion into a different class of stock, often used in investment rounds involving debt or equity.

2. How is the warrant coverage percentage determined? Warrant coverage is typically negotiated between the company and investor, often ranging from 10% to 25% of the investment amount, depending on risk, leverage, and company stage.

3. Do warrants expire? Yes, most warrants have an expiration date ranging from five to ten years. After that date, if unexercised, they become void.

4. Can convertible warrants dilute existing shareholders? Yes. When exercised, convertible warrants increase the total shares outstanding, which can dilute the ownership percentages of existing shareholders.

5. Are convertible warrants taxed? Tax treatment can vary. If warrants are issued without a separate purchase price, the IRS may classify part of the investment as a discount, potentially triggering taxable events. Consulting a tax professional is advisable.

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