In a jargon-filled world of straight equity, subordinated debt, sweat equity, term loans and lines of credit, what the heck is a warrant anyway? In definitional terms, the warrant gives its holder the right to purchase a share of stock at a future point in time, for a specified price. Most importantly, warrants serve an almost perfect duality of purpose: They entice investors with the promise of future riches if things work out, and they put into place a fairly reliable future influx of capital if you meet those expectations.
Here's how a hypothetical entrepreneur might use warrants to bring in investment dollars and make sure they keep coming once the business takes off. Assume the following scenario: An early-stage growth company in the communications technology industry with $1 million in revenue is seeking $1 million in capital. Further assume that similar, early-stage communications tech companies are being valued at three times their revenues, meaning our hypothetical enterprise is worth $3 million. As a result, for the $1 million our entrepreneur needs, he or she is willing to give up about one-third of the company ($1 million investment/$3 million valuation).
Finally, assume the entrepreneur runs into the kinds of resistance from investors that typify the plight of all entrepreneurs trying to raise capital:
- Your management team is incomplete at the time of the deal.
- There is uncertainty about your company's ability to successfully develop the product.
- Even if you are able to develop the product, there is no pool of established customers with a track record of paying for the product.
- You are too small to have much power in distribution channels.
- There are no significant barriers to entry, and anyone can come in and eat your company for lunch.
To help investors with the many challenges they've conjured up in their minds, our entrepreneur might make the following offer: `If you buy one million shares from me at $1 each, I will give you the right to purchase more shares for a price of $2 apiece for a period of three years.' That offer, technically speaking, is called a warrant.
From this rather pedestrian definition, it's hard to see how warrants offer much incentive at all. But consider this: Would you like to be holding a security today that gives you the right to buy several thousand, or several hundred thousand, shares of online giant America Online for mere pennies per share? With today's market as it is, that offer sounds great. But when the ramped up sales to $5 million. Now our hypothetical venture is valued at $15 million, and each of the three million shares outstanding are worth $5 ($15 million/three million shares). Meanwhile, our lucky investors have an option to purchase shares for $2. If the investors exercise their warrants to purchase one million shares at $2, the company will raise $2 million. And since investors are buying stock worth $5 for only $2, they will earn (but probably not realize) a gain of 150 percent.