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Don’t you just hate it when technical jargon is used and isn’t explained? The term “warrant” is used all the time in angel discussions, but when I talked with several newer angels recently, almost none understood what a warrant really is and they didn’t want to ask for fear of sounding stupid. Their thinking is along the lines of “if I’ve been an angel for a year and heard this term again and again, I must be an idiot if I don’t understand the basics.” I’m here to say that isn’t true.
Here are some FTQs (Frequently Thought, but rarely asked, Questions) about warrants:
What is a warrant? Like stock options for company employees, stock warrants are contractual rights for investors or other key third parties to buy stock in the company at a preset price for a set time period . In the case of early stage deals, they are offered as an incentive to invest – a mechanism that will allow an investor to increase their position in the future for today’s price. Early stage companies also use them in connection with the establishment of a credit facility – some lenders will ask for warrants as part of the lending deal.
How are warrants a reward for investors? The primary advantage is that the investor has the right to benefit from the company’s future success without having to put his or her money at risk today. Here’s why: there is no need to “exercise” the warrant if the company fails. But if the company is doing well, warrant holders can exercise their “in-the-money options” for additional profit as part of the transaction.
What are the key elements of a warrant? There are a couple of key items in a typical warrant agreement, including:
- The number of shares the investor is entitled to purchase in the future
- “Exercise price,” also known as “strike price” – the minimum future stock price that require the warrant holder to purchase the warranted shares. Sometimes the price is similar to the price of the investor’s original purchase, but the price could also be for the Fair Market Value of the stock at the time they are granted, or what is negotiated anywhere in between.
- Expiration date – warrants expire at some point. There are examples of 15-year time periods, but most warrants expire five or ten years after they are contracted.
Warrant holders are looking for the stock price to exceed the exercise price before the expiration date in order to get the upside benefit of the warrant. When this happens, the warrants are “in the money.” It should be noted, though, that in the risky world of early-stage investing, it is possible for the stock price to go down after the angel invests, making the warrant worthless.
When are investors offered warrants? Ideally, warrants are given to investors and others who are important to the success of the business. This could be lead investors or advisors and vendors who help the business. As top angel and Angel Capital Association Chair Christopher Mirabile writes, sometimes they are used to “sweeten the deal” to convince angels to invest sooner rather than later in a new round of financing. Mirabile, adds “they are sometimes used instead of a discount to make convertible notes perform more like equity.”
So give me an example of how this works. Here’s one from Rockies Venture Club: “Early investors who committed to the first round of P2Bi’s Series A funding received warrants for up to 50% of their investment amount with half expiring two years after the close of the transaction and the other half expiring a year later. The warrants allowed the investors to purchase additional shares at the original offering price of $1.50.”
“Someone investing $50,000 would have the option to purchase up to $25,000 worth of additional shares at the original offering price of $1.50 up to the second anniversary of the deal, or if that was not exercised, they could still purchase up to $12,500 worth of shares by the third.”
When is the best time to exercise a warrant? Mirabile says the best strategy is to wait until you are sure the company “is totally out of the woods (and the warrants will therefore definitely be worth something) and then, once you have made that determination, exercise them as soon as possible to start the capital gains clock running so it hopefully has at least a year to run before any acquisition occurs. That way they are treated as long term capital gains with a preferential rate, as opposed to short term capital gains, which are taxed at the same rate as ordinary income.”
Hopefully this answers some questions you were afraid to ask! Now you know a little more about warrants and what it means when you hear exercise price, strike price and in the money. Find more resources for understanding angel terms and best practices here.
