A Warrant, also called a Stock Warrant, is a certificate that entitles the holder (the person to whom the Warrant is issued) to purchase a certain number of shares of common stock, at a stated price, for a specified period of time. Warrants are the equity kicker which investors require to target their expected return Without the warrant, the return would be equal to the interest rate or dividend.
The amount of Warrants offered represents how much equity dilution you are taking, or how much equity you are giving up. The amount of equity you give up is a function of the investor’s expected return, which takes into account the dividend or interest rate, whether the dividend or interest is paid currently or accrued, and the value of the common equity at the end of the investment horizon.
The exercise price of a warrant is the price at which the warrant holder pays for the common stock. In a private transaction, the exercise price warrant can be set at any price, and is typically set at $0.01 per share. A higher exercise price just means that the investor will require more shares to achieve the targeted return.
A cashless exercise feature is a way to convert the warrant shares into common equity without writing a check. For example, if you have 5,000 penny warrants and the market value of the common equity is $5.00 per share. You would use 10 shares as currency to purchase your 5,000 shares at $0.01 per share, or $50.00. Your net proceeds would then be $24,950, or (5,000 – 10) x $5.00.
Warrants will typically come with a Put/Call feature. The Put feature allows the warrant holder to monetize his investment by forcing the issuer to redeem the warrant. The Call feature allows the issuer to buy the warrant shares away from the warrant holder, which can be useful if the issuer believes that the value of the equity will be greater than it is at the time the Call is exercised.
The right to Put the warrant shares back to the issuer typically becomes available to the warrant holder any time after five years. The Call rights of the issuer will typically become available 12 months later, or after year six in this example if the Call is available after year five.
The Put or Call of a warrant is completed at the market price, which is tricky to say the least for a private company where the common equity is not traded. The Warrant Agreement should have language that either 1) predefines a formula to determine the value of the equity, or 2) provides for a process to determine the value of the equity.
Predefining the value of the warrant is straight forward, the simplest is assigning a multiple to the then-current EBITDA to arrive at an enterprise value. From the enterprise value subtract all debt and preferred stock, and add unrestricted cash to arrive at the equity value. The “exit multiple” is usually the “going-in multiple”. The downside of this methodology is that someone is potentially leaving money on the table; i.e. the company may be worth more or less than the value suggested by the formula.
Providing for a process to value the equity comes down to the hiring of a valuation firm to determine the value of the equity. In the event one of the parties disagrees with the value determined by the valuation firm, the warrant agreement should provide for a resolution that will usually allow for the dissenting party to hire a second valuation firm. If there is still disagreement, then the two valuation firms will hire a third firm with a final value determined by taking the average of all three valuations.