Oct 4 2011 by Jason

Convertible Debt – Warrants

Earlier in the convertible debt series we talked about the “discounted price to the next round” approach to providing a discount on convertible debt. The other approach to a discount is to “issue warrants”. This approach is more complex and usually only applies to situations where the company has already raised a round of equity, but it still pops up in early stage deals. If you are doing a seed round, we encourage you not to use this approach and save some legal fees. However, if you are doing a later stage convertible debt round, or your investors insist on you issuing warrants, here’s how it works.

Assume that once again the investor is investing $100,000 and receives warrant coverage in the amount of 20% of the amount of the convertible note. In this case the investor will get a warrant for $20,000.

This is where it can get a little tricky. What does $20,000 worth of warrants mean? A warrant is an option to purchase a certain number of shares at a pre-determined price. But how do you figure out the number of warrants and the price that the warrants will be at? There are numerous different ways to calculate this, such as:

  1. $20,000 worth of common stock at the last value ascribed to either the common or preferred stock;
  2. $20,000 worth of the last round of preferred stock at that’s rounds price of the stock; or
  3. $20,000 worth of the next round of preferred stock at whatever price that happens to be.

As you can see, the actual percentage of the company associated with the warrants can vary greatly depending on the price of the security that underlies it. As a bonus, the particular ownership of certain classes may affect voting control of a particular class of stock.

If there is a standard, it’s the second version where the warrants are attached to the prior preferred stock round. If there is no prior preferred, then one normally sees the stock convert to the next preferred round unless an acquisition of the company occurs before a preferred round is consummated and in that case, it reverts to the common stock.

For example, assume that the round gets done at $1.00 / share, just like in the previous example. The investor who holds a $100,000 convertible note will get $20,000 of warrants, or 20,000 warrants, at an exercise price of $1.00, to go along with the 100,000 shares received in the financing from the conversion of the note.

Warrants have a few extra terms that matter.

Term Length: The length of time the warrants are exercisable which is typically five to ten years. Shorter is better for the entrepreneur and company. Longer is better for the investor.

Merger Considerations: What happens to the warrants in the event the company is acquired? We can’t opine more strongly that all warrants should expire at a merger unless they are exercised just prior to the transaction. In other words, the warrant holder must decide to either exercise or give up the warrants if the company is acquired. Acquiring companies hate buying companies that have warrants survive a merger and allow the warrant holder to buy equity in the acquirer. Many a merger have been held up as warrants with this feature have upset the potential acquirer and thus as part of the closing requirements mandated that the company go out and repurchase and / or edit the terms of the warrants. This is not a good negotiating spot for the company to find itself in. It will have to pay off warrant holders while disclosing the potential merger (so the company will have little leverage) and at the same time will have a sword over its head by the acquirer until the issue is resolved.

Original Issue Discount: This is an accounting issue that is boring, yet important. If a convertible debt deal includes warrants, the warrants must be paid for separately in order to avoid the OID issue. In other words, if the debt is for $100,000 and there is 20% warrant coverage, the IRS says that the warrants themselves have some value. If there is no provision for the actual purchase of the warrants, the lender will have received an “original issue discount” (OID) which says that the $100,000 debt was issued at a “discount” since the lender also received warrants. The issue is that part of the $100,000 principal repaid will be included as interest to the lender, or even worse, it will be accrued as income over the life of the note even before any payments are made. The easy fix is paying something for the warrants, which usually is an amount in the low thousands of dollars.

The difference between warrants and discounts is probably insignificant for the investor. We suppose if the investor is able to get warrants for common stock, then perhaps the ultimate value of warrants may outweigh the discount, but it’s not clear. As evidenced by the number of words above, warrants add a fair amount of complexity and legal costs to the mix. On the other hand, some discounts will include valuation caps (more on this in our next post) and that can create some negative company valuation ramifications. Warrants completely stay away from the valuation discussion.

Finally, in no case should an entrepreneur let an investor double dip and receive both a discount and warrants. That’s not a reasonable position for an investor to take – he should either get a discount or get warrants.