The Definition And Meaning Of Warrant Coverage

For companies looking to attract investors, a warrant coverage agreement can help to sweeten the pot. 

Warrant Coverage Definition

In some cases, investors and companies may disagree on the exact intrinsic value of a firm. In such scenarios, warrant coverage agreements can help to entice investors to invest in a company. Typically, warrants come attached to debt, but can also attach to preferred stock as well. 

A warrant coverage agreement entitles an investor to purchase shares in a company at a particular agreed-upon price. This agreement usually constitutes a certain percentage of the original investment. In other words, the investor has a right to purchase common stock at a particular price on or before the expiration date. 

To better understand these agreements, consider how warrants function in corporate finance.

Understanding Warrants

Warrants grant investors the ability to purchase shares in a firm at a particular price prior to an agreed-upon expiration date. These instruments dilute the pool of common equity in a firm. Two types of warrants exist:

1. American Warrants: Investors can exercise an American warrant any time on or before the expiration date. 
2. European Warrants: Investors can only exercise a European warrant on the expiration date. 

As you read the above, you likely see the similarities between warrants and options. The main differences between warrants and options include:

• Companies alone issue warrants for investors, whereas any set of parties can enter into an options contract. 
• At the time an investor exercises a warrant, the company will issue new shares to fulfill the contract. Regular options entail the use of outstanding shares. In this way, warrants act as a dilutive security since they reduce the value of every share at the time the investor exercises them. 
• Warrants typically, though not always, have much larger gaps of time between the issuance date and the exercise date compared to options. 

The number of shares an investor may purchase depends on the warrant coverage agreement. 

Warrant Coverage Reasons

To better understand why a company might issue warrants to an investor, consider the following hypothetical scenario:

• A pre-growth startup accepts a $100,000 investment in the form of a convertible note. A convertible note begins life as debt but can convert to equity at a predefined rate depending on agreed-upon conditions. This note also has 5% warrant coverage. 
• The startup next raises funds from a venture capital firm at the price of $1 per share. At this time, the convertible note converts to equity at a price of $1 per share. The investor now has 100,000 shares in the company. 
• Since the original note had 5% warrant coverage, the investor can now purchase an additional 5,000 shares at a price of $1 (5% * 100,000). 

In this way, a company with uncertain future prospects can create an additional sweetener to convince an investor to make a larger investment. Warrants functionally act as a long-term incentive plan to attract investors to a company that has yet to achieve product-market fit or begin its growth trajectory. 

Some types of investors may also make these investments, including venture debt lenders and professional traders. 

Warrants vs. Other Types of Securities

Why would a company issue warrants as opposed to other types of securities? Find the pros and cons below: 

Pros

• An investor can receive a major benefit if the price of the underlying shares of the firm rises above the exercise price of the warrant. In this scenario, an investor could exercise their warrants and purchase shares at a lower price for resale to produce a cash profit. 
• Investors who otherwise would not wish to invest in a firm may have an additional incentive to back a new company. 
• Warrants give financial managers of a firm an additional lever by which to attract early-stage capital. Mature firms may also make use of warrants, too. 

Cons

• Warrants function as complex instruments known as derivatives. Both companies and investors should use caution when transacting warrants. 
• From a company’s perspective, warrants act as dilutive securities. Too much dilution can anger other shareholders in a company due to the reduction in equity value-per-share. For mature companies, dilution may cause an activist investor to take note and recommend management changes. 
• Given the length that warrants can remain exercisable, these instruments can expose companies to a long-term dilution risk. This fact has ramifications on the cost of capital for the firm with respect to both the cost of equity as well as the cost of debt. 
• Shareholders of a company may not wish for management to issue securities with warrants. 

The CFO’s Perspective on Warrants

Chief financial officers (CFOs) have the ultimate authority on the strategic financial activities of a firm. Making use of warrants and other derivatives falls under the authority of the finance department at a company. 

Small business owners and founders of fast-growing startups may also make use of warrants as well to entice investors to make an investment in their firms. 

Other forms of financing may offer more benefits to business owners compared to warrants. Forms of financing such as term loans, revolvers, credit cards, invoice factoring, and merchant cash advances can help businesses to raise funds without creating an equity dilution event. 

By carefully balancing these different variables, businesses can make smarter decisions in attracting investment capital while ensuring the continued growth in the value of the company. 

Next Steps for Small Businesses

For small business owners considering raising funds from investors, warrants can offer a helpful solution to bring additional investment into the firm. However, businesses should weigh the benefits of warrants in attracting early-stage investors against the downsides of equity dilution, since each additional share issued further dilutes the original founders of the company. 

Nevertheless, warrant coverage agreements can help companies to avoid the expense and other downsides associated with equity financing and the covenants that come with debt financing.