A Warranted Discussion
Our founders and clients are always looking for ways to optimize their capital. Whether they’re boot-strapped or venture-backed, different companies have different priorities when it comes to spreading their capital around. Our founder, Joe, recently put on a training for a client compensating their employees with options. Options are a great way to compensate employees, but what if you utilize consultants? What if you want to attract outside capital or upgrade a debt deal? What if you need a creative way to compensate service providers? If you’ve been asking yourself these questions, a discussion is probably WARRANTED.
Stock warrants, similar to stock options, give the holder the right to purchase or sell stock at a specified price in the future. Warrants are issued directly by a company, and are subject to the terms of the warrant certificate. The warrant certificate lays out the terms including the issue date, exercise or strike price and the exercise period. Again, this all sounds pretty option-y. So how about we take a look at the similarities and differences between warrants and options. Get the table!
|
|
Options |
Warrants |
|
Option to Buy or Sell Stock |
Yes! |
Yes! |
|
Exchange-Listed |
Maybe!1 |
No! |
|
Long-Term Exercise Period2 |
No! |
Yes! |
|
Dilutive |
Yes! |
Yes! |
|
Used to Raise Capital |
No! |
Yes! |
|
Used to Compensate |
Yes! |
Not Normally! |
Stock warrants can be an excellent way for an early stage company to raise capital. Warrants can be attached to debt instruments as a sweetener in order to reduce interest rates. Banks and financial institutions will sometimes request warrants in order to share in the upside performance of the company when issuing credit facilities and borrowings. Suppose a bank or private debt fund is willing to issue a term loan to a promising start-up at a rate of 8.5%. Issuing warrants to the lender may drop the interest rate to 7.0% reducing the start-up’s interest expense, while allowing the bank the opportunity to invest early and share in the upside. They can also be offered in addition to early round financing in order to attract larger investment from lead investors; a lead investor committed to $5M in Series A financing, may provide additional capital knowing there are warrants available for additional equity investment. .
To Buy or Not to Buy: The Purchaser
We not only work with the promising start-ups of tomorrow who are issuing warrants, but also the funds and investors who are looking for attractive equity stakes in these companies. Let’s take a look at how warrants work on a basic level from the purchaser’s perspective. The purchaser buys 100 warrants from Company ABC for $1,500. These warrants have a strike price of $50. When they decide to exercise the warrants, the stock is worth $100/ share. The simple math looks like this:
|
A. Warrant Purchase Price |
$1,500 |
|
B. Strike Price x # of Shares |
$5,000 |
|
C. Total Investment Cost (A + B) |
$6,500 |
|
D. Value of Stock at Exeris ($100/share x 100 shares) |
$10,000 |
|
E. Ordinary Income (D-E) |
$3,500 |
The warrant purchase price can be thought of as the price to play, while the strike price will be quoted in the agreement as the cost per share once the warrants are exercised. The warrant purchase price plus the strike price equal the investment cost. Once warrants are exercised, the purchaser will receive some freshly issued shares; this is important to note, as new issuances dilute the existing shareholder pool. The difference between the value at exercise and the investment cost is taxed at ordinary income rates for the purchaser. If they decide to hold onto the stock, the exercise price ($10,000) becomes the new cost basis. If these shares are sold after holding for a year, they’ll be subject to long-term capital gains rates, a preferred tax rate.
Decisions, Decisions; Should We Issue Warrants, Options, or No Securities At All?
Employee stock options look similar to warrants in practice with a few nuanced differences. The difference between the exercise price and market price on the date of exercise is referred to as the bargain element, and is to be included on the employee’s W-2 as compensation. It’s taxed at ordinary income rates and subject to standard employee withholdings.
One of the major downsides of issuing warrants is their dilutive effect, as discussed earlier. When warrants are exercised, new shares are issued by the company who then sells them to the warrant holder (at exercise price). Options are typically the right to buy or sell existing shares, so exercise doesn’t increase the number of shares outstanding. This is an important point when deciding whether to issue options or warrants; will my existing shareholders be diluted?
Our fund clients are always looking for attractive incentives to invest their capital, and our consumer and technology clients are looking for ways to attract that capital. Offering warrants attracts capital, and provides an instrument for investors to share in the upside performance of growth companies. If you’re considering issuing warrants or options, it’s important to consider what they’re being used for, and what the effect on the cap table and existing shareholders will be. These types of decisions always warrant a discussion.
This article was written by Brandon Bohl.