Stock warrants

What is a stock warrant?

A stock 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 used to incentivize 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 and liquidation preferences come into play.

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.

Exercise price

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.

Vesting structure

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 the warrant holder can exercise the warrant to receive shares.

Term

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.

Exit event

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.

→Learn more about the differences between options and warrants

When should you issue a warrant?

There are a few distinct situations where it’s helpful to issue warrants:

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.

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 as part of the deal for the loan. Many bank lenders may lower your interest rates or otherwise amend your loan payment terms in exchange for a warrant.

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:

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.

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.

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.