When someone says the word “warrant,” what’s the first thing comes to your mind? Perhaps the image of a sheriff knocking on a suspect’s door? While that might be what most people first envision, founders, service providers and investors in the emerging company ecosystem often find themselves discussing a different type of warrant.
In the securities context, a warrant is an instrument that gives the holder the right to purchase a specific number of equity securities, within a specific time frame, for a set exercise price. Warrants are often used in connection with private offerings and startup financings, primarily to compensate third-parties involved in an offering and to “sweeten” the deal for investors providing equity or debt financing to a company. (If you’re looking at a cap table, you’ll normally see the effect of warrants in the “fully diluted” capitalization of the company.)
In both cases (compensation and yield enhancement), warrants provide equity upside to the holder: if the underlying company performs well, the warrant holder benefits.
Key terms of a warrant (all of which are heavily negotiated) include the following:
- Underlying security
- Warrants are typically exercisable for common equity.
- However, it’s not uncommon to see warrants exercisable for preferred stock.
- The company usually represents that the stock underlying the warrant authorized and reserved for issuance.
- Size or share number
- This is the number of equities securities for which the holder may exercise the warrant.
- Some warrants must be exercised in full; some permit partial exercise.
- Exercise price
- This is the price that the holder must pay for each share of equity underlying the warrant.
- This can be a fixed price, or a formula hinging on future financings or corporate events.
- A number of tax provisions apply to the determination of a warrant’s exercise price, but in general a warrant is priced close or at a premium to the value of the underlying equity at the time the warrant is issued.
- Some warrants have “cashless exercise” provisions, which permit the holder to use the inherent value of the warrant as a credit, such that no consideration is owed if the warrant is exercised under certain circumstances.
- As it sounds, this is the length of time during which the holder can exercise the warrant.
- Mechanical anti-dilution
- Mechanical anti-dilution rights provide protection against stock splits, dividends, recombinations, and certain other corporate reorganization events.
- Price-Based anti-dilution
- Price-based anti-dilution rights protect the warrant holder from equity dilution from a subsequent issuance of shares at a price lower than what the investor originally paid.
- Transferability restrictions
- Generally, transfers are only permitted is they comply with applicable securities laws.
- Service providers will often seek to pre-approve certain transfers to their agents or principals.
- Companies may impose a requirement to obtain a legal opinion prior to any proposed transfer.
- Registration rights
- Registration rights refer to the right of the warrant holder to register his warrant shares for public issuance.
- Two common types are “demand” and “piggyback” registration rights.
- Demand rights allow the warrant holder to make an individual demand for the company to register its shares (likely under certain conditions).
- Piggyback rights allow the warrant holder to “piggyback” on a demand made by another group or class of equity holders.
- Tag along right
- This gives a shareholder the right to join in a transaction to sell his warrant shares if another shareholder is selling his stake.
- Put option
- This allows a warrant holder to require the company to repurchase the warrant.
- Call option
- The inverse of a put, this allows the company to require warrant holders to exercise.