As an accounting firm specializing in startups, we often encounter questions about various financial instruments. One instrument that plays a significant role in startup financing is warrants. Let’s look at what warrants are and why they matter for your startup.
What are warrants?
Warrants are financial instruments that give the holder the right to buy a company’s stock at a specific price (known as the exercise or strike price) within a set time period. They function similarly to stock options but are typically issued to external parties rather than employees.
How startups use warrants
For venture-backed startups, warrants serve several important purposes:
- Fundraising incentives. Warrants are often issued to investors as “deal sweeteners” during fundraising rounds. They provide an additional incentive for investors to participate in your startup’s growth.
- Debt financing. When securing venture debt, lenders may require warrants as part of the financing package. This allows them to potentially benefit from the startup’s future success, offsetting the risk of lending to a high-growth, unprofitable company.
- Strategic partnerships. Warrants can be used to cement relationships with key strategic partners, aligning their interests with the startup’s long-term success.
- Advisor compensation. Key advisors may receive warrants as part of their compensation package, incentivizing them to contribute to the company’s growth.
Benefits of warrants for startups
For startup founders, warrants provide flexibility and control. Founders can use warrants to attract strategic partners, advisors, or other providers without giving up equity right away. Your ownership isn’t diluted until the warrant is exercised, and when it is exercised, your startup gets capital. In contrast, stock options give employees an immediate ownership stake in the startup, which means the founder’s ownership is diluted.
Warrants offer several other advantages for startups:
- Lower upfront costs. Warrants are typically issued at a lower cost than stock options, because they have a longer exercise period. That allows startups to provide incentives at a lower initial expense.
- Longer exercise periods. As noted, warrants usually have longer exercise periods (often 3-5 years), which means they can be priced lower than options and have more flexibility for holders.
- Alignment of interests. By offering warrants, startups can align the interests of investors, lenders, and key stakeholders with the company’s long-term success.
- Additional future capital. When warrants are exercised, they provide an additional source of capital for the startup without the need for a new financing round.
Important considerations for startups issuing warrants
While warrants can be valuable financing tools, startups should keep the following in mind:
- Dilution. Outstanding warrants can impact future ownership dilution. It’s crucial to carefully consider the potential dilution when issuing warrants.
- Accurate tracking. Warrants represent potential future stockholders, so they need to be tracked carefully. You should use capitalization table software to make sure your records are accurate.
- Negotiating terms. When issuing warrants, your startup should carefully negotiate terms such as anti-dilution provisions, transferability restrictions, and call provisions. You should consult experts to make sure you understand all of the terms and how they will affect you and your company.
- Legal and financial advice. As noted above, given the complexity of warrants, it’s important to seek specialized legal and financial advisory services if you’re considering issuing warrants for your startup.
Managed carefully, warrants are an effective tool
Warrants can play a major role in your startup’s financing strategy, helping you to attract investors, secure debt financing, and align your interests with key stakeholders. Financial tools like warrants can contribute significantly to your company’s growth and success. However, you need to carefully consider their implications and make sure that you properly manage any warrants you issue.
