Warrant Coverage On Debt: Are You Getting Robbed?
Warrants can add up to 20% extra annual interest.
If a lender asks you for warrants as part of their term sheet, are you able to translate the value of those warrants into the overall cost of debt?
It’s actually pretty easy and it largely depends on your growth rate over the life of the debt.
An example: an early growth stage company, with $5M in revenue and EBITDA negative, needs capital to continue its growth trajectory of 25% per annum. A lender offers $2.5M in funding in exchange for 14% annual interest plus 2% warrant coverage.
Do you know what those warrants equate to in terms of extra annual interest?
First, what does X% warrant coverage mean? It can either mean as a % of the loan principal or it can be of the total company outstanding shares. Normal values might be 10% to 20% warrant coverage on the value of the loan or 1% to 3% of the total company.
In this case, we are using 2% of the total company. Those warrants should have a strike price of current FMV but often lenders ask for a much lower strike price (aka “penny warrants”) which is effectively giving away 2% of your company.
Software companies are valued as a multiple of revenue and that multiple increases as revenue breaks through thresholds. A $5M revenue company might be worth 4X while a $10M company might be worth 6X. If our example company doubles revenue over 4 years, moving from $5M to $10M, then the valuation increases from $20M to $60M.
The 2% penny warrant coverage is worth $1.2M at exit.
However, there is one other hidden “gotcha” in the calculation. It’s easy to compare the $1.2M with the $2.5M loan, spread over 4 years and calculate the interest. However, that would be incorrect. The warrant cost needs to be applied against the average loan balance outstanding over the 4 year term, not the opening loan balance; just like interest is. The loan balance declines over time as the company makes payments.
So lets assume the average loan balance over 4 years is $1.25M as the loan gets paid equally down over time.
Now, the warrants worth $1.2M are applied against an average loan balance of $1.25M or a staggering 96% cost over 4 years. Break that down to an annual rate and they cost 24% extra interest per year on top of the 14% base rate paid in cash. Even if you assume the warrants have a FMV strike price at issuance, the extra interest is 16.7% per annum.
The next time someone tags on warrants to your debt termsheet, make sure you fully understand the value of those warrants before making your decision.
