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Investing in early stage companies is a difficult balancing act of risk vs. the potential for future reward. Warrants are often used as additional inducement for early investors to invest in a company. A company may issue warrants by themselves or may include them as part of a deal for investors purchasing debt securities or preferred stock. What is a Warrant? A traditional warrant provides the holder the right, but not the obligation, to purchase a specified number of shares of common stock of a private company, during a specified time period, at the fair market value of the shares at the time the warrant is issued. The anti-dilution provisions in a warrant are the most heavily negotiated provisions. The purpose of an anti-dilution provision is to protect the holder from being diluted because the company issues additional equity in the future. Startup Example Deal Early stage investors commit to a company’s Series A funding round and receive warrants equal to 25% of their initial investment that expire in one year. In other words, the early stage investors have the ability to purchase up to 25% of the total number of shares they initially purchased at the same price per share as their initial investment, provided that they exercise the warrants within the one-year period. Why use Warrants? There is always a risk that any deal will not be executed and become profitable. For startups this is usually a big risk. Even when the investors are excited about the idea, they remain uncertain about how the company will perform after making an investment. Warrants allow investors to observe how the company performs against projections before deciding whether they want to make an additional investment at the same price that they initially invested. Needless to say, investors like to be able to use the benefit of hindsight prior to making additional investments. Bottom Line: Warrants are often used as additional inducement for early investors to invest in a company and can be used to bridge the gap in perceived execution risk between the founders and the early stage investors. For more articles about Finance, Business and Law, please visit www.biztaxbuzz.com
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