As your company grows and scales, you may have to issue both stock options and warrants at one point or another. As a founder, you likely already know your stock option basics, but warrants can be a bit more confusing.
To further your equity knowledge, we’re breaking down everything you need to know about warrants, including what they are, how they’re different from stock options, and when to issue them.
What is a warrant?
A warrant is an agreement between two parties that gives one party the right to buy the other party’s stock at a set price, over a specified period of time. Once a warrant holder exercises their warrant, they get shares of stock in the issuing party’s company.
The key components of warrants
Before you explore the possibility of issuing warrants, it’s important to understand how they work. Here are four components of a warrant:
Type of stock
You can issue a warrant for common stock or preferred stock. While common stock is generally reserved for founders and employees, preferred stock is typically reserved for investors. Preferred stockholders are usually the first to get paid out if a liquidity event occurs.
When you issue a warrant, you have to specify which type of stock the warrant applies to. However, you can also specify that the warrant is exercisable for a new series of preferred stock issued in a later financing round.
The exercise price, also called a strike price, is the price you agree to pay for each share a warrant includes. With a warrant, you could set the exercise price at the fair market value (FMV) of the stock at the time of issuing, or, for a non-compensatory warrant, a lower price, such as a penny per share.
Like stock options, warrants can come with a vesting structure, but they don’t have to. Depending on your company goals and the person—or entity—you issue the warrant to, you could create a vesting structure based on either time or performance. Keep in mind that if you develop a performance-based vesting structure, you’ll have to outline the specific milestones or targets a warrant holder has to hit before exercising their shares.
Every warrant comes with a term, which is usually between two and 10 years. The expiration date, which marks the end of the term, is the date at which the warrant holder can no longer exercise the warrant for shares. Warrant holders typically want longer terms, so they can wait for the company to appreciate in value before making the decision to pay the exercise price.
If you sell your company or go public, your warrants will be affected. The terms of a warrant usually require the company to give the warrant holder advance notice of an exit event, so the holder can decide whether or not they want to exercise their shares.
Warrants vs. stock options
Like a warrant, a stock option is a contract that gives the holder the right to buy or sell stock at a certain price over a specified period of time. Though options and warrants are similar, they’re used in different situations for different purposes. Here are two distinguishing factors:
1. They’re issued to different parties.
Companies generally issue stock options to service providers—such as employees, advisors, or contractors—as compensation or as an incentive to stick around longer. Warrants can be issued to service providers too, but it’s less common. Instead, companies primarily issue warrants to investors, banks, and third parties when entering a commercial or financial transaction.
2. They have different exercise prices.
You have to set the strike price of stock options at the fair market value (FMV) of one share at the time you grant the option—regardless of how much your shares go up in value over time.
On the other hand, when you issue warrants for non-compensatory purposes, you can set the exercise price much lower than the FMV, sometimes for a penny per share.
When should you issue a warrant?
There are a few distinct situations where it’s helpful to issue warrants:
1. During an early financing round
If you’re fundraising, you may want to issue warrants to help incentivize investors to participate, usually alongside a convertible note. A warrant may also help satisfy investors who might have ownership percentage requirements you can’t meet right away. If, for example, a strategic investor wants to invest $2 million in your company but you’ve only allocated $1 million for your seed round, you can issue a warrant that becomes exercisable only if the investor contributes to your company’s goals as expected. The result: you can reach your fundraising goals and incentivize early investors without over-diluting your shares.
2. When you’re getting a loan from a bank
If you’re getting a loan from a bank as part of a venture debt agreement, the bank may ask for a warrant before entering the deal. Many bank lenders may lower your interest rates or otherwise amend your loan payment terms in exchange for a warrant that promises future equity in the company.
3. To reward partners for their services or incentivize them to enter a deal
Issuing a warrant as part of a partnership agreement can help you maintain great relationships with third parties, not to mention push certain projects forward. If your company is a startup, for example, you could issue a warrant to an incubator in exchange for the facilities, network connections, or talent they provide.
You could also issue a warrant if you’re negotiating a deal with a third party and want to sweeten your offer. Maybe you’re talking to another company about teaming up to put out a new product. Or perhaps you’re offering your software services to a larger corporation in exchange for access to their customers. In each of these scenarios, issuing a warrant could help you align your goals more easily and reach a compromise.
What to know before issuing a warrant
If you’re considering issuing a warrant to seal a financial deal or further a partnership, here are three things to keep in mind:
1. Develop an effective vesting structure
If you decide to include vesting restrictions on your warrants, you need to be thoughtful about how you do it. Poorly designed vesting structures could inadvertently encourage messy or self-interested behavior from your warrant holders. To ensure your warrant works for you, you need to create a vesting structure that’s easy to define, abide by, and track.
The structure should also work with your goals. If you need help expanding your network, for example, you might want to create a performance-based vesting system wherein you ask your warrant holders to introduce you to a certain number of investors by a specific date. Ultimately, a well-designed vesting structure should help you reach your company goals more easily, while still motivating your warrant holders.
2. Watch out for excessive dilution
As with any type of equity you issue, warrants can dilute your existing stock. When a warrant holder exercises their warrant, you’ll have to issue them shares of stock, which means your current shares will be diluted and your ownership percentage may drop. To ensure you’re not over-diluting your shares, you need to be careful about the amount of warrants you issue.
3. Add warrants to your cap table
Because a warrant is exercisable, you need to include it on your company’s cap table and track its progress. If you don’t, you risk complicating your cap table and potentially discouraging future investors from joining in a future round. For help structuring and managing your cap table, check out Carta’s cap table management software.
To warrant or not to warrant
Warrants can be helpful tools to secure financing or incentivize strategic partners, but it’s important to structure them correctly. Otherwise, not only will your warrant not be as appealing to an investor or third party—it also won’t be as valuable to you. To set yourself up for success, talk to your business attorney to see whether or not warrants make sense for your company goals and growth plan.
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DISCLOSURE: This publication contains general information only and eShares, Inc. dba Carta, Inc. (“Carta”) is not, by means of this publication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This publication is not a substitute for such professional advice or services nor should it be used as a basis for any decision or action that may affect your business or interests. Before making any decision or taking any action that may affect your business or interests, you should consult a qualified professional advisor. This communication is not intended as a recommendation, offer or solicitation for the purchase or sale of any security. Carta does not assume any liability for reliance on the information provided herein.