What Is Warrant Coverage?

Written by

Meow Advisory, LLC

Published on

Monday, January 8, 2024

What Is Warrant Coverage?

Warrant coverage is an important concept for companies seeking investment, especially high-growth startups looking for venture capital. In essence, warrant coverage gives investors the right to purchase additional shares in a company at a fixed price in the future. This helps protect their investment, while providing additional upside if the company performs well.

For startups and growth companies seeking funding, understanding investor expectations around warrant coverage is key. Though not all investors require warrants, they are common in many funding instruments like convertible notes, SAFEs, and venture debt deals. Negotiating warrant coverage requires balancing investor requests against potential dilution of existing shareholders.

Defining Warrant Coverage

A warrant gives an investor the right, but not the obligation, to purchase company stock at a predetermined price up until an expiration date. The strike price is typically set at or close to the valuation of the company's most recent funding round.

Warrants are normally expressed as a percentage of the investor's capital contribution. For example, an investor putting in $1 million into a startup may request a 10% warrant coverage. This would give them the right to purchase $100,000 of additional shares at the strike price in the future.

The percentage of warrant coverage requested and eventual terms granted can depend on factors like perceived investment risk, company stage, and negotiation leverage on both sides.

Why Investors Want Warrants

Investors request warrant coverage for several key reasons:

  • Downside protection - Warrants give investors the right to purchase more shares at a set price even if subsequent valuations fall. This protects them against dilution in later rounds.
  • Participation in upside - Similarly, if the company grows significantly in value, investors can exercise warrants to lock in more shares at a discount to the current fair market value. This allows them to capture more upside from their investment.
  • Overall returns - Gains from warrants helped boost the returns of successful deals within an investor's overall portfolio. Since startup investing is risky, warrants provide a mechanism to enhance IRR.

In essence, warrant coverage allows investors to maintain their proportional company ownership by participating in future fundraising rounds one way or another.

Why Companies Provide Warrant Coverage

From the company perspective, providing warrant coverage has its advantages as well:

  • Attract investors - Granting warrants can make the funding terms more appealing to investors and secure their investment. This is especially relevant for high-risk, early-stage startups.
  • Investor participation - Warrants provide an incentive for invested shareholders to double down and participate in future rounds to capitalize on their coverage rights. This continued support can be beneficial.
  • Future cash flow - If warrants are exercised, the company brings in additional capital. Though there is dilution, it also provides resources to grow the business.

Understanding the Tradeoffs

There are also notable disadvantages and risks related to providing warrant coverage:

  • Dilution - Any exercised warrants mean dilution for existing shareholders since new shares are issued. Investors get to buy shares at set prices even as the true market value may have risen significantly.
  • Loss of control - If an investor's ownership increases via exercised warrant shares, it reduces proportional control for founders and employees.
  • Mixed incentives - Warrant investors might push for "liquidity events" like a quick sale to capitalize on their holdings, rather than focus on the long-term growth trajectory.

It's important to model potential dilution levels and outcomes before agreeing to warrant coverage terms. The percentages granted should reflect a fair compromise given the stage of the business.

Key Terms of Warrant Coverage

If warrant coverage will be included in a funding round, pay attention to the key terms:

  • Number of shares - The allotment of additional shares the investor has rights over expresses the dollar amount as an absolute share figure or a set percentage of their investment.
  • Strike price - This preset price per share is either fixed or set as a discount to the subsequent round’s price per share.
  • Expiration date - The right to exercise warrant coverage expires on a set future date, typically 3-5 years from the initial investment.
  • Vesting - Warrants may vest and become exercisable in tranches based on milestones or date.

These terms require planning around future funding needs and dilution limits because they are essentially commitments to issue more shares.

Warrant Valuation Considerations

Several variables affect the fair market value of a warrant:

  • Underlying stock price - Warrants become more valuable as the trading price per share rises.
  • Strike price and premium - A lower strike increases warrant value. The percent difference between strike and market prices denotes the intrinsic "moneyness" value.
  • Time value - Longer duration until expiration means higher warrant value.
  • Volatility - Stocks with higher volatility command higher warrant valuations.
  • Risk-free rate - Rising baseline interest rates increase overall warrant valuations

Assessing the Fair Balance on Warrant Coverage

Offering warrant coverage has valid strategic reasons on both sides of the table. Investors have to equally assess their risk-return profile when negotiating the right warrant terms.

From the startup’s perspective, warrant coverage improves funding prospects and attracts crucial investor support. But founders need to gauge resulting dilution, loss of control, and incentive alignment issues.

Smart negotiators try to quantify warrant values based on assumed scenarios and find an equitable compromise. Being too generous or rigid on coverage terms can either lead to unnecessary dilution and loss of control or botched funding deals.

Navigating these tradeoffs and aligning interests is key to an optimal long-term outcome.

Learn More about Venture Debt

To Learn more about Venture Debt you can read our free guide for Beginner's here: https://www.meow.com/venture-debt-guide

This free guide to Venture Debt walks through key terms, what to consider when raising venture debt and a list of lenders to get started with.

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