Are Loan Warrants the Right Form of Venture-Debt Financing for your Startup? Find Out Here.
Finding financial backing for your startup can be an arduous and complicated process. With all the different types of funding and financial jargon, it’s easy to get lost or have trouble figuring out which would be best for the success of your small business.
When it comes to venture financing, there are many ways in which investors will attempt to recoup their initial investments and make profits. One such deal is called a loan warrant. But what is a loan warrant and is it a viable option to fund your business?
What is a Loan Warrant?
A loan warrant is a type of incentive-based venture deal in which a company offers the investor the right to buy stock at a specific price between a certain period of time. Similarly to stock options, investors are granted the access to buy (but not forced to buy) at a set price in hopes of selling that stock at a higher price once the company is performing in a profitable manner.
The price at which the loan warrant holder can buy back company stock is called the strike or exercise price. This price is valid for the agreed upon period in the initial offering, which can range anywhere from one to fifteen years depending on the deal and amount of shares.
The number of shares a lender or investor receives as part of the deal is commonly referred to as coverage. Coverage is usually expressed/negotiated as a percentage of the loan amount, not the company valuation. Once the percentage is negotiated, that price is then converted to the equivalent value of purchasable shares that can be exercised within the set expiration period.
Loan Warrants vs. Stock Options
Loan warrants and stock options are similar in nature, but have several key differences that make them attractive or advantageous to different investors.
The main difference between a loan warrant and stock option is that loan warrants are company-issued. That means that exercised shares come directly from the company and not from another agency or investor. When a loan warrant is exercised, the investor is given a certificate of purchase proving ownership of the stock. In order to make money, the purchased stocks will still need to be sold. Companies can also issue stock warrants to raise additional capital on their stock offerings.
Inversely, stock options are usually traded investor to investor. Stock options are generally purchased when an investor believes the price will fluctuate in order to make a profit. Buying an option you believe will go up is called a call option. Buying an option you believe will go down is called a put option.
When stock options are exchanged, the company does not make or lose money. However, since loan warrants are issued directly from the company, they usually have an effect on the company’s overhead and stock price.
Loan warrants are typically better long term investments for VC’s as well, as they can last up to fifteen years, whereas stock options generally expire within a year or two after not being vested.
Risks and Rewards
As with any form of investing, loan warrants come with a set of risks/rewards for both companies and investors.
As the company, you are risking equity and ownership stake, similarly to other stock deals or funding ventures. As an investor, you’re risking your funds in support of a company that may not turn a profit or be profitable for quite some time. This is why interest rates for such deals can be in the double-digits.
On a positive note, warrants don’t provide investors with any ownership state until they are exercised. This means you won’t have to give up any decision making or board seats in order to receive funding. However, if the warrant is exercised within the set period, you will be relinquishing part of your company without the additional help of brand oversight and leadership decisions other types of venture funding may provide.
Ideally, an investor would never exercise a loan warrant unless a company is being liquidated or if the value has increased drastically by the expiration date. The incentive to own part of the company or share in profits should be enough to attract investors as well as secure their investment if things happen to go south. Precisely why it’s beneficial to have a relationship with potential lenders previously or built upon it after the investment so you both have a clear understanding of expectations and goals.
In the end, finding the right investment funding comes down to the type of company, amount and stage of funding and finding the right investors that believe in your products or services. And while loan warrants are becoming more prevalent in the SaaS space, they are not the only funding option. When researching different types of venture-debt funding for your business, be sure to consider similar deals the lender may have made in the past in addition to weighing the risk/rewards it could have on your overall business and marketing plan.