What it means
A warrant is a contract that gives its holder the right, but not the duty, to buy shares at a fixed price before a set date. When a lender receives warrants with a loan, the arrangement is called a loan with warrant coverage.
The coverage is stated as a percentage of the loan. A figure of 10% on a $2,000,000 loan means the lender may buy shares worth $200,000 at the agreed exercise price, which is usually set at the price of the company's latest funding round.
Lenders ask for coverage because start-ups are risky and interest alone may not compensate for the chance of loss. The warrants add potential reward when the company succeeds, so the lender can accept a lower rate than it would otherwise charge.
For founders and existing shareholders the cost is dilution (a smaller ownership share). The company should work out how many shares the warrants could create and compare the total cost with the alternative of raising more equity.
Terms to negotiate include the exercise price, the expiry date, whether the warrants can be exercised without paying cash, and what happens if the company is sold or goes public. The details matter as much as the headline percentage.
Accounting for warrants can be technical. The company usually values the warrants when they are issued, often with an option pricing model, and records part of the loan proceeds as the value of the warrants, which affects the reported interest cost over the life of the loan.
In practice
Real-world examples.
Example
A software start-up raises $5,000,000 of venture debt with 8% warrant coverage. The lender receives the right to buy $400,000 worth of shares at the last round price, and the interest rate is lower than a plain loan would carry. The company's board compares the two costs before agreeing.
Example
A medical device company negotiates the coverage down from 15% to 10% in exchange for a larger loan commitment. On a $5,000,000 loan with a $4.00 exercise price, 15% coverage would cover 750,000 / 4.00 = 187,500 shares while 10% covers 500,000 / 4.00 = 125,000 shares, so the finance director calculates that the founders avoid 62,500 shares of dilution.
Example
A lender holds warrants that are worth nothing for two years, because the company's share price has not risen. When the company is acquired at a higher price, the lender exercises the warrants and earns a gain on top of its interest. The warrants turn a modest loan return into a much better result for the lender.
Formula
Calculation
Warrant value covered = loan amount x warrant coverage percentage
Number of shares = warrant value covered / exercise price per share
Suppose a start-up borrows $2,000,000 with 10% warrant coverage and an exercise price of $4.00 a share. The warrant value covered is 2,000,000 x 0.10 = $200,000. The number of shares is 200,000 / 4.00 = 50,000 shares. If the company later has 10,000,000 shares in issue, the lender's potential ownership is 50,000 / 10,050,000 = about 0.5% once the warrants are exercised.Case study
Seen in the real world.
Brightfield Biotech is an illustrative, fictional company that needed $3,000,000 to bridge a gap before its next equity round. The lender offered a loan at 10% interest with 12% warrant coverage at an exercise price of $6.00 a share.
The finance director worked out that the coverage was worth 3,000,000 x 0.12 = $360,000, giving the lender the right to buy 360,000 / 6.00 = 60,000 shares. She then compared the dilution with the alternative of raising extra equity at a lower valuation.
Because the next round priced shares well above $6.00, the warrants were more valuable to the lender than expected, but the company still preferred the loan to issuing more shares early. The illustrative lesson is that coverage is a price paid in ownership, and it should be weighed against the other costs. Brightfield now asks every lender for a dilution calculation before it signs a term sheet.
Watch out
Common mistakes.
- Reading warrant coverage as an amount of cash the lender receives, when it is the size of a right to buy shares.
- Ignoring the exercise price, which decides how much profit the warrants can make.
- Forgetting to model the dilution that the warrants would cause when they are exercised.
Questions
People also ask.
How is warrant coverage different from an interest rate?
Interest is paid in cash while the loan is outstanding, whereas coverage gives the lender a share of the future upside if the shares become more valuable.
What is a typical coverage percentage?
It varies by deal and lender, and it is often in the range of 5% to 20% of the loan, depending on risk. Stronger companies can often negotiate lower coverage.
Are the warrants lost if the loan is repaid early?
Usually not, because the warrants are a separate contract that normally survives repayment unless the agreement states otherwise.
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