Many Golden Returns
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The failure rate for new businesses is high. But in truth, most new enterprises don't fail because they can't generate enough business--they fail because they just plain run out of money. When, for instance, you're pouring more and more capital into inventory and selling to new markets, it doesn't matter that your existing clients are paying their bills on time. The fact is you can't sell your way out, and to keep the show going, you need an outside infusion of cash.
The two corollaries to this hard truth are as follows: First, no matter how badly you need this outside capital, it will be expensive and difficult to entice investors to put money into your risky venture. Second, you will not be able to reach your goal with a singular outside investment. Raising money begets the need to raise more money.
These realities lead to a maneuver that should be in the corporate-financing playbook of every entrepreneur: warrants.
David R. Evanson's newest book about raising capital is called Where to Go When the Bank Says No: Alternatives for Financing Your Business(Bloomberg Press). Call (800) 233-4830 for ordering information. Art Beroff, a principal of Beroff Associates in Howard Beach, New York, helps companies raise capital and go public, and is a member of the National Advisory Committee for the SBA.
A Closer Look
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.
Fire When Ready
Truth be told, in our example, it's unlikely the investors have gotten any less cagey or any more confident in the intervening two years, even though the company has performed. Sure, they can buy $5 stock for $2, but only in theory, unless it's a public company. As a result, most warrants have some kind of mechanism allowing the entrepreneur to pull the trigger, so to speak, and get the investors to exercise their option to buy more shares.
This trigger mechanism is often called a "redemption feature," and it works like this. In addition to giving investors the right to purchase additional shares, warrants offer the company the right to buy the warrants back from the investors, often for just a few cents. So in the case of our hypothetical venture, here's how it might play out.
At the point in time when the company's shares are well above the exercise price, the company will notify the shareholders of its intention to redeem the warrants, say, for a penny per warrant. Now investors have a choice to make. Ante up another $2 per share to stay in the game and realize an immediate $3, or 150 percent, gain, or check out and receive just a penny per warrant. Three dollars vs. $0.01. Faced with that hard choice, most investors will exercise their warrant, or at least the company hopes so.
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.