Definition of Warrants
Warrants in a financing context are securities that give the holder the right, but not the obligation, to purchase a certain number of shares of a company’s stock at a specified price, known as the strike price, before the warrant expires. They are often issued in conjunction with loans or bonds as an added incentive for lenders or investors, effectively giving them potential equity upside in the company’s success.
How Warrants Work in Financing
In venture debt, warrants allow the lender to convert part of their exposure into equity shares, usually at the valuation of the last funding round or at a predefined price, if the company performs well. If the company’s stock value rises above the strike price, the warrant holder can exercise the warrant, purchase shares at the lower price, and either hold or sell them at market value for a profit. If the company does not perform well, the warrants may expire worthless, while the lender still earns interest from the loan.
Why Warrants Exist in Debt Deals
Warrants make debt deals more attractive because they can provide returns similar to equity if the company grows significantly. For this reason, they are commonly used to enhance lender returns beyond interest payments. However, warrants are dilutive to founders because exercising them results in new shares being issued, reducing the ownership percentage of existing shareholders.
Warrants Explained for a General Audience
For a general audience, warrants are similar to stock options that a company gives to a lender or investor, allowing them to buy shares later at a fixed price. They act as a “kicker” in a deal: a company receives a loan, and in addition to paying interest, agrees to let the lender buy a portion of the company’s stock at the current valuation. If the company becomes much more valuable, the lender can buy shares cheaply and either keep them or sell them at a higher price, earning additional profit. From the company’s perspective, this means giving away a small slice of future equity in exchange for immediate funding. Many startups accept this tradeoff because the immediate capital is valuable, even though it causes dilution.
Example of How Warrants Create Value
If a startup’s current implied share price is $5, a lender may receive warrants allowing them to buy shares at $5 within a five-year period. If the company grows and the share value reaches $20, the lender can exercise the warrants at $5 and realize a $15 gain per share. If the share price stays the same or declines, the warrants are not exercised.
Warrants in Venture Debt vs Ratio’s Model
In the context of Ratio’s discussion, venture debt often includes warrants, which introduces dilution for founders. Ratio’s financing model does not include warrants, which is a key selling point. Using Ratio Trade or Boost funding does not require founders to give up any equity upside, as the financing is structured purely around contracts. This allows founders to maintain full ownership. Warrants can also complicate future equity rounds or exits, as warrant holders may later exercise and become shareholders. Ratio’s True Sale approach avoids this entirely.
Why Warrants Matter in a Glossary Context
Explaining warrants completes the picture for readers exploring venture debt or alternative financing options, as warrants frequently appear in these discussions. Clarifying that warrants are essentially options to buy stock at a fixed price helps demystify the concept for non-finance audiences. By understanding warrants, founders can better evaluate financing options and recognize why avoiding warrants may be more founder-friendly.
Summary
Warrants are rights granted to lenders or investors to purchase shares at a set price in the future, providing potential equity upside. They are a common component of venture debt and other financing structures but can dilute founder ownership if exercised. Because of this, many companies prefer financing solutions that avoid warrants altogether. Ratio’s solutions do not include warrants, making this a notable competitive and structural difference.
