The returns for a venture loan come from two sources – cash (in the form of interest and fees) and equity (in the form of warrants). Warrants give the lender an option to purchase shares of the company at some future date for a specified price. Warrants are sometimes called an “equity kicker” because they can boost the return of a loan beyond the coupon and fees.

I like warrants. We always want our companies to be successful but with warrants involved our returns are more closely aligned with everyone else.

I also like that warrants can be structured in a variety of ways and they’ll have no impact on how a loan gets repaid. What I mean by that is that other terms of a loan – such as principal repayments and cash interest – can be structured creatively as well but if done incorrectly could put a strain on cash flows. Warrants can’t do that. (Well, a warrant with a put option could and I would recommend to any company to avoid a put option except in some fairly rare circumstances).

A typical warrant section of a term sheet might read something like this:

“the lender will be granted 12% warrant coverage, exercisable into Series A Preferred Shares with an exercise price of €2.00. The warrants will have the same anti-dilution protection as the Series A Preferred Shares and will last for ten years.”

There are a few terms to know when talking about warrants:

-        Coverage amount. How many warrants are granted is often expressed in the form of “warrant coverage.” For example a loan for €1.0 million with 12% warrant coverage would give the warrant holder the right to buy 12% of €1.0 million, or €120K, worth of shares.

-        Underlying shares. The term sheet should specify which shares the warrant will exercise into. This is typically the most recent round of shares, such as the Series A Preferred shares. Some warrants exercise into common shares. Be sure to have this specified because each share class carries its own rights such as liquidation preferences.

-        Exercise price. Typically set at the price paid for the round in question. If no exercise price is specified be sure to check that the warrants are not a share grant. There is a big difference – with an exercise price the holder pays for each share whereas with a share grant he does not.

-        Life. Warrants are typically granted with a ten year life although some more mature companies will push for a shorter life such as 7 years which can make sense given they are closer to an exit than earlier stage startups. Warrants are typically exercised prior to a change of control or IPO.

These are the basic terms for warrants. In a later post I will cover some creative warrant structures but I find that these basics cover most of the situations companies will see.