Many Golden Returns

Cases For And Against

One of the advantages of the redemption feature is that it happens at the discretion of the company. Presumably then, it can deliver relatively quick financing at a moment in time when the company needs capital.

Another advantage of warrants is, as indicated above, speed. Remember, raising money from a standing start can often take six months or more. For a company in the throes of a growth spurt, six months to find money just doesn't cut it. For some companies, especially fast-growing Internet companies, the game is over in six months.

These advantages, however, compelling as they are, must be weighed carefully against two big drawbacks associated with the use of warrants. First, look at our hypothetical example of the communications technology company. If the company is worth $5 per share, why then would the entrepreneur be willing to sell shares for a mere $2 per share. Why indeed?

Remember, the redemption feature is used at a moment in time when the economics are so compelling to the warrant holders that they almost can't pass up this opportunity to buy more shares. The other side of this arbitrage, however, is that the company ends up selling shares cheap, sometimes too cheap.

Therefore, the wisdom of exercising warrants can be reduced to these two rules. Exercising warrants is ill-advised if new investors are banging down the door trying to get into your deal, because presumably they would pay top dollar. On the other hand, exercising warrants would be a good idea if convincing new investors of the new and higher value of the company looks like it will take a long time.

Ah, but why not issue warrants, just in case? Not a bad idea, but it brings us to our second drawback: Warrants can get in the way of other financings, particularly IPOs. For instance, an investment banker will balk at the fact that he or she is doing everything possible to sell shares in the company to their best customers for, say, $12 per share, when there is an entire group of investors, who, through their warrants, have the right to purchase shares for $3 per share. Therefore, just the existence of warrants can scuttle an IPO.

The same argument is sometimes posited by professional, or institutional, venture capitalists. Venture capitalists are often managing funds on behalf of investors, who rail against paying one price for equity, when other investors can buy in for much, much l

But the final and perhaps fundamental guiding principle of entrepreneurial finance is to do whatever needs to be done to raise the required capital. For most companies, raising funds is an uphill battle. And given this reality, it's probably best to use whatever tools are at your disposal to get the job done, and as for the future, let the chips fall where they may.

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This article was originally published in the March 2000 print edition of Entrepreneur with the headline: Many Golden Returns.

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