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Using
Warrants In Your Private Placement
Offering
If you’re
in the market raising junior capital, you’ll
need to understand how warrants are used in
structuring your offering. If you are floating
a Private Placement of preferred stock or
subordinated debt, your investors will expect
to have warrants attached to their
security.
What is a
warrant?
A warrant
is a security that gives the warrant holder the
right to purchase equity at a specific price,
within a certain time frame. Without the
warrants, the investor or lender would only
receive the dividend yield or interest rate on
his shares or loan, hardly compensating him for
the risk of making the investment. This
equity-kicker is what gets investors
excited.
Warrants
are usually expressed as a percentage of the
“fully-diluted” common stock of the company,
which then equates to a certain number of
common equity shares.
Fully-diluted refers to the total
number of shares that would be outstanding if
all conversions take place; e.g. convertible
securities, employee stock options, and
warrants, including the warrants which are part
of your offering.
Warrants
will usually have a “nominal” exercise price,
also known as “penny warrants”. In the context
of a buyout where the majority of the equity
capital is in the form of preferred, the common
equity will only have a nominal value. In other
situations, the common equity may be valued at
a higher number in which case i) the warrants
will have an exercise price at the market value
of the common equity, or ii) the warrants will
have a nominal price, but the number warrant
shares will be less.
As you
structure your transaction and write your
Private Placement Memorandum, you should become
familiar with some terms that you’ll need to
include in your term sheet:
Anti-dilution rights protect the
warrant holder from equity dilution from a
subsequent issuance of shares at a price lower
than what the investor originally
paid.
A simple
example - suppose an investor received warrants
for 20% of the equity for a preferred
investment $1 million. If the Issuer
subsequently issued another $1 million of
preferred with warrants for 30% of the equity,
the first investor would be diluted from 20%
equity to 14% equity if there were not any
anti-dilution protection language.
There are
a number of ways to address anti-dilution, but
that discussion is beyond the scope of this
article.
Demand and
piggyback registration rights refer to the
right of the warrant holder to register his
warrant shares for public issuance. The
difference between the two types of
registration rights is that Demand registration
allows the holder to initiate the registration
of warrant shares for public issuance. Demand
registration is usually reserved for majority
warrant holders, or warrant holders who have a
significant ownership. Piggyback registration
means that the warrant holder may have his
warrant shares registered along with another
holder or the company if there is a registering
of the company’s shares. Piggyback rights are
for the benefit of minority investors, as only
the majority investors will have Demand
registration rights.
Tag-along
rights give a shareholder the right to join in
a transaction to sell his shares if another
shareholder is selling his stake.
Preemptive
rights give shareholders the right to purchase
new securities being issued by the company
prior to them being issued to new, outside
investors. In the dilution example above, a
preemptive right would have given the first
investor the right to purchase a proportional
amount of the new issuance to preserve their
equity ownership.
Note:
since there would be an anti-dilution provision
in the shareholders agreement, the
anti-dilution provision would require waiver by
the shareholders to proceed with the new
issuance.
A Put
Option allows the warrant holder to “put” the
warrant back to the company. When the warrant
is put to the company, the company has an
obligation to purchase the warrant back from
the investor. It is a way for the investor to
monetize the value of his equity stake. The
price that the company pays for the warrant is
the product of the equity value of the company
and the percent of the fully-diluted equity
represented by the warrant shares.
A Call
Option is a way for the company to “call” in
the claims on its common equity. A company may
call its equity back from investors if it
anticipates an increase in the value of its
equity down the road. It is also a way for the
company to consolidate ownership back to, say
the sponsors of the transaction.
I had a
situation once where an investor requested that
we eliminate the Call Option. His rationale was
that he wanted to ride the value and did not
the equity value get called away from
him.
There are
no rules for the number of years for the
investor to have its Put right, or the Issuer
to have its Call right, except that typically
the advantage is to the investor with the Put
right occurring before the Call right. My
experience is that Put/Call rights will usually
occur in years 4/5 or 5/6.
The issue
you will face will be determining the value of
the equity if and when the Put or Call gets
exercised (except if there is a sale of the
company to an unrelated third
party).
I have
been in transactions where the equity value for
the purposes of the warrant was negotiated
upfront as the greater of i) a liquidity event
(such as a sale) or ii) a formula.
For
example, if the original transaction was valued
at 5x EBITDA, then the valuation for the
Put/Call was also 5x EBITDA. Keep in mind that
the product of a multiple and EBITDA gets you
to an Enterprise Value, which is not the same
thing as the equity value. To get to equity
value, you’ll need to subtract debt and add
cash (unrestricted cash).
My
experience is that if there is no predetermined
formula, the value of the warrant is usually
negotiated. The “fair market value as
determined by a …” language is for when you
can’t agree; however, you should always have
this language even if you have a
formula.
As the
Issuer you may find that the formula is based
on the just-ended fiscal year, but by the time
the audit gets completed, there might have been
a material adverse change in the business such
that the agree-upon formula overstates the
value of the equity. Conversely, if you are the
investor, events subsequent to the audit may
point to a significantly higher equity value
than what would be indicated following a
formula using the year-end numbers.
Warrants
are just another tool that help you raise the
capital you need. The trickiest part of the
whole warrant conversation will be
anti-protection. As the Issuer you will want to
run through a variety of scenarios to make sure
you understand how your value will be impacted
when anti-dilution triggers kick
in.
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