We don't usually post new content on Friday's but with the launch of the new site (thanks Webflow!) we figured let's take this thing for a test drive. One thing that I know confused me as a first time founder trying to raise capital from investors for the first time was when someone mentioned to me that they would want a warrant in the deal. Warrants can sound intimidating but as you know here at Talkin' SaaSy we like to try and break things down so they are more digestible so let's get into warrants, long story short, an IOU for investors.
Early-stage investing is speculative and risky business. More often than not angels or early-stage funds are taking bet on founder they believe in that are working on a product or solution to a problem that they believe will have broad market application. Now early-stage investors protect themselves from this risky business, first is diversification of their portfolio, more promising startups means you are more likely to have a few winners in your portfolio (in theory). Second is warrant coverage, how exactly does this help?
Warrants are essentially an IOU from a company to an investor as part of a funding round. Say I put $250,000 into a seed round of your budding SaaS startup at $1.00 a share. For early-stage investing like this, a fund or angel is counting on that price per share multiplying many times, if it goes to $40.00 per share, my $250,000 is now $40M, sounds like a nice return, right?. Well my seed fund is a $50M fund which means even if i hit one company that goes from 1 to 40 dollar per share, I'm still $10M short on breaking even with my fund, yikes. This is where warrants come in, for those early-stage investors, maximizing the number of shares you can get in your winners is a key for driving fund performance.
So now, in that same seed round, I included a warrant for 20% of the round meaning the company, if I exercise the warrant. Must sell me and additional $50,000 shares at a strike price (a strike price is just a set price that is agreed upon in the warrant, it means the investors get to buy shares of the stock at the set strike price, no matter what the actual price is in the most recent funding round). So, with my 20% warrant, I am entitled to purchase an additional $50,000 worth of shares at a $2.00 strike price. So if that same company goes to $40.00 a share and I exercise my warrant I turn my $50,000 into an extra $1,000,000, as an investor I just got much closer to returning my fund and I haven't even take into account pro-rata right (we will get into that another time).
Warrants on their surface are meant to help companies looking to raise capital. In theory, the investor is incentivized to help the business do better and thus the warrant becomes more valuable. The issue is, most early-stage funds typically have warrants in all of their deals, so no matter which deal wins, they get to leverage that warrant into great ROI for the fund. How could we rethink warrants to better align outcomes and incentivize investors to help startup succeed? Is it a sliding performance scale? The better the startup grows and performs the better the terms of the warrant are for investors? It will be interesting to see if we can rethink how we use warrants to help align the outcome for founders and investors. Disclosure, warrants are used in multiple types of investing and this article is only meant to summarize their use in private venture investing. This is also a very simplified summary of warrants, if you are using a warrant in a funding round always comply with securities law and consulte a legal professional.