Warrants

First, a disclaimer: I am not a lawyer or a financial advisor and am not offering financial or legal advice.

What are warrants? #

Warrants are legal agreements that give the holder the right, but not the obligation, to purchase a company's stock at a predetermined price (the exercise or strike price) within a specified time frame. The are often granted to investors, advisors, business partners, lenders, and other stakeholders as part of a financing round or other agreement. When granted to equity investors or debt lenders, warrants are often used to sweeten the deal for investors by offering them the opportunity to purchase additional shares at a fixed price if the company performs well, and can be important in debt or bridge financings where there are higher risks.

Warrants are commonly granted as either a number of warrants or a dollar amount, which may be cited as "warrant coverage", which refers to the percentage or dollar amount of the warrants relative to a financing or lending agreement. Warrants will have exercise prices (also called strike prices), which is the price at which the warrant holder can purchase shares, and the exercise price is often set to reflect the current value of the company or some minimal par value per share (e.g. $0.01 per share, or penny warrants).

How warrants and options compare #

While warrants and options are similar in that both grant the right to purchase a company’s stock at a predetermined price, warrants are typically issued to external stakeholders, while options are usually granted to employees as part of a compensation package. Additionally, warrants are often exercised cashless, meaning the warrant holder does not pay the exercise price in cash but instead receives a reduced number of shares, while options are exercised by the option holder paying the exercise price to the company in cash.

How warrants impact cap tables and waterfalls #

Warrants may appear on a cap table if they are denominated in shares or a dollar amount with a fixed exercise price, so that the number of warrants can be calculated. They will typically be shown next to the equity holders for the type of shares (preferred or common) that they can purchase.

Warrants are usually exercised when there is a liquidity event such as an exit (acquisition, merger, or sale of the company) or an initial public offering (IPO). Warrants with a expiration date may also be exercised before they expire if the warrant holder thinks they will be worth more than the exercise price.

When warrant holders exercise warrants, they turn in the warrants and receive shares in exchange. The number of shares received depends on whether the exercise is cash-based or cashless:

Cash-Based Exercise #

The holder pays the exercise price in cash to purchase the specified number of shares. For example, if a warrant allows the holder to purchase 1,000 shares at $10 per share, they pay $10,000 to acquire those shares.

In a liquidity event, the warrant holder would pay the exercise price in cash to the company to receive the shares, and then receive the distribution of proceeds due to those shares. Continuing from the example above, if the proceeds due to the warrant holder's shares were $50 per share, the warrant holder would pay $10,000 to the company to receive 1,000 shares and then receive the $50,000 in proceeds due to those shares, netting $40,000.

Cashless Exercise #

In this scenario, the holder does not pay the exercise price in cash but instead receives a reduced number of shares. The "foregone proceeds" is the value of the shares the warrant holder does not receive in exchange for not paying the exercise price. When a warrant holder exercises cashlessly, they receive fewer shares than they would if they paid the exercise price in cash, and the foregone proceeds are effectively absorbed by the existing equity holders.

The key is caculating the number of shares foregone in a cashless exercise:

Net Shares = (Fair Market Value - Exercise Price) / Fair Market Value × Number of Warrants Outstanding

The number of shares calculated here would be the number of shares to be allocated to the warrant holder in the cap table used to calculate the distribution of proceeds in the liquidity waterfall. Note that the number of net shares will vary by the exit price, so you must calculate the number of shares separately for each exit price.

Continuing from the example above, the number of shares the warrant holder would receive in a cashless exercise would be 1,000 shares * (50 - 10) / 50 = 800 shares, which would be 800 * 50 = $40,000 in proceeds. The warrant holder would not pay the exercise price, and in return would receive a smaller number of shares, but the proceeds would be the same.

The Cap Table and Exit Waterfall Tool has options in the pre-distribution cap table in the Exit waterfall and Exit Waterfall, Extended sheets to choose whether to use cash or cashless exercise for any warrants that you enter into the cap table. The Exit Waterfall, Simple sheet assumes cashless exercise for all warrants.

For more background on warrants, Allen Latta's post Private Company Warrants: An Overview is a great place to start.