WHAT YOU SHOULD KNOW ABOUT WARRANTS

OLIVIER SINOCELLI

UK review by Ryan Naftulin

If you’re negotiating for equity financing, bridge financing, bank financing, venture debt, or a commercial transaction for your startup, you may be asked to issue a warrant as part of the deal. This COOLEYGO’ article explains what a warrant is, and outlines some of the key terms to understand.

What is a Warrant?

A warrant is an agreement between two parties – the “issuer” (i.e., a company) and the “holder” of the warrant – that entitles the holder to purchase the issuer’s stock at a specified price within a certain time frame.

That Sounds Like a Stock Option – What’s the Difference?

Warrants are very similar to stock options in their basic terms and structure, and in the context of high-growth emerging companies the differences mostly stem from who the relevant parties are. For example, companies commonly issue stock options to employees and other service providers as a benefit or added incentive to work hard.

By contrast, warrants are typically issued to incentivize a third party to enter into a financial or commercial transaction. For example, a warrant may be issued to an investor (in addition to stock or a convertible note) in a financing, to a bank that is providing the company with a debt facility, or to a commercial or strategic partner. The potential upside associated with the warrant in the event the company’s stock appreciates significantly adds “a little something extra” to incentivize the other party to enter into the deal.

In addition, most issuers’ option plans only allow for issuances of options to individuals providing service to the issuer, with very limited exceptions – so issuers are typically unable to grant options to third party investors, lenders and commercial partners.

Key Features of Warrants

Here are some of the key terms of a warrant:

Number of Shares of Stock

The number of shares of stock exercisable under the warrant, together with the type of stock and the exercise price (both explained below), are fundamental economic terms of the warrant. The number of shares of stock underlying the warrant is typically expressed as a fixed number, as a formula, or perhaps some combination of both. For example, a warrant issued to a bank may specify an initial number of shares based on the original loan amount, and also provide that the number of shares will increase if the company borrows additional funds under the loan facility.

Type of Stock

High-growth emerging companies typically issue warrants for common stock or preferred stock, depending on the context of the transaction. In most cases the exact type of stock is known and specified in the warrant; however, it can get slightly more complicated. For example, the holder of the warrant could be able to choose to receive a new series of preferred stock to be issued in a future financing, if one occurs.

Exercise Price

The exercise price (also known as the “strike price”) is the agreed upon price to be paid for each share underlying the warrant at the time of exercise. The exercise price could be the fair market value of the stock at the time of grant, or some other price. In some cases the price is set at a nominal price of $0.01 (called a “penny warrant” or “pre-funded warrant”). The exercise price is usually, but not always, expressed as a known fixed number. It could also be derived from a formula, or it could be the price paid for a new series of preferred stock to be issued in a future financing.  Issuers typically have more flexibility in setting the material terms of a warrant issued to a third party than they do in the case of issuing options to service providers.  See below for more on this circumstance.

Method of Exercise

Most warrants will be freely exercisable in whole or in part by paying the cash exercise price. Many warrants also allow for what is called a “cashless exercise,” which allows the holder to exercise without paying cash by reducing the number of shares receivable by the holder by an amount equal in value to the aggregate exercise price that the holder would otherwise have to pay. Since the value of the exercise price is “netted out” from the shares that the holder receives upon exercise, this is sometimes called a “net exercise.”  In the case of an issuer that is a private company, oftentimes the ability to cashless exercise is limited to a sale or public offering of the issuer.

Term/Expiration Date

The expiration date is the date the warrant can no longer be exercised, and it sets the term of the warrant. Most warrants have terms of between 2 and 10 (and sometimes up to 12) years, depending on the nature and circumstances of the deal. Typically, the longer the term is the more valuable the warrant is, since it provides more opportunity for a significant payout if the company has a successful exit or the stock otherwise appreciates in value.

Treatment in a Sale of the Company or Other Corporate Events

One of the key terms in many private company warrants is what happens to the warrant in a major corporate event, such as a sale of the company. Many warrants require advance notice of such an event, to enable the holder to decide whether or not to exercise. In many cases, the warrant will provide that either the warrant will be deemed automatically exercised immediately prior to the sale (usually through a cashless exercise) if the acquisition price is above the exercise price, or that the warrant will be assumed by the buyer.

Similarly, a warrant may provide for specific treatment (e.g. advance notice, termination or automatic net exercise) in the case of the company’s IPO.

We’ve outlined some of the most common terms above, but warrant terms have many different variations and nuances. In particular, warrants issued in some circumstances may have tax consequences to the issuer or the holder if not structured and accounted for properly.  If you’re an issuer considering whether to issue a warrant in the context of a specific transaction, it’s important to review all of the terms and discuss them with your legal counsel.

Contracts and obligations under Ukrainian Civil Law (materials)

Share