Venture Capital Terms: Warrant Coverage

Warrant CoverageLast week I posted a short description of some common terms that are used to describe a company’s valuation on a venture capital term sheet. While everyone who negotiates a term sheet is likely aware of the importance of valuation during the negotiation, many other terms have a large impact on the deal and yet are often overlooked by entrepreneurs raising capital.

When a term sheet includes warrants issued to investors, the equity held by entrepreneurs and other common stockholders at the company will be further diluted. Therefore, the effect of warrant coverage should be carefully considered while negotiating the terms of a venture financing.

What is warrant coverage?

Warrants are additional shares that are issued to VCs on top of the shares they purchase with their invested dollars. The issued warrants typically carry the same terms and privileges as the purchased shares (e.g. liquidation preference). The warrants that are issued as part of a financing can be expressed as a flat share count, but they are often expressed as a percentage of the purchased shares, called warrant coverage. For example, if a VC invests $1M in a company at $1 / share, they will purchase 1M shares. If the terms of the financing include 30% warrant coverage, the VC will also receive an additional 300,000 shares in the form of warrants.

The effect of warrant coverage

As described in my last post, valuation is, and should be, a main focus of any term sheet negotiation. Even if a company is able to negotiate a favorable valuation, the benefit can be largely offset by other terms. Warrant coverage is no exception to this rule. For example, suppose a VC initially proposes a $5M pre-money valuation. The company pushes back, and eventually manages to get the investors to accept a $6M pre-money. This means that if the VCs invest $5M, they will own only about 45% of the company, rather than the 50% they would own at the originally proposed pre-money.

However, even with the $6M pre-money, if the term sheet includes 20% warrant coverage, then the VCs will effectively receive 20% more shares than were actually purchased with their investment. Thus, even though they invest only $5M, they will receive $6M worth of shares. Including the issued warrants, the VCs will own 50% of the company, effectively negating the benefit from the negotiated $6M valuation.

Summary:

  • Warrants are shares that are issued on top of those purchased by VCs during a venture financing.
  • Warrant coverage can offset the effect of a negotiated valuation.