Introduction

Financing start-ups has never been straightforward. If investors are going to support a start-up, they want to be compensated for the increased risk associated with a shorter track record. Sometimes, a favorable term is needed to sweeten the deal for an investor because it increases their return if the start-up performs well. One common way to do this is by issuing warrants that are included into a Term Sheet.

In a venture capital deal, the “Term Sheet” or “Letter of Intent” is a critical document. By concentrating on the Term Sheet, the firm seeking investment (the “Company”) and the Venture Capital investor (the “Investor”) may concentrate their attention on the critical business aspects addressed by the proposed investment. The parties may rapidly agree on significant parameters or realize that the investment is unfeasible due to irreconcilable disputes on basic problems. In any instance, time and money are saved in the drafting process.

Non-binding Term Sheets

The process of developing and negotiating a Term Sheet contributes to the transaction’s solidification and the establishment of a feeling of momentum between the parties. A well-written and detailed Term Sheet will streamline the process of producing the final contracts, hence reducing the time and effort necessary to create and negotiate the final agreements. Additionally, a well-produced Term Sheet may aid the Company in negotiating with critical allowance partners, creditors, suppliers, and consumers, among others.

Simply because the document produced by the parties is referred to as a Term Sheet, it does not indicate that it may never be used to generate a legally enforceable contract. As a result, the Term Sheet should expressly state that it is not binding on either the Company or the Investor in and of itself. Rather, all responsibilities must be conditional on the negotiation and signing of final agreements, as well as the Investor’s previous acceptable completion of extra due diligence. Otherwise, the Investor may be compelled to make an investment according to the Term Sheet that future inquiry or circumstances indicate was not in its best interests.

A noteworthy exception to the Term Sheet’s non-binding character sometimes occurs in the area of spending. Term Sheets usually state that, although the primary clauses are non-binding, the Company will bear certain expenditures incurred by the Investor, even if the transaction is never finalized. If this is the parties’ goal, the Term Sheet should expressly declare that such a clause binds the parties legally. If the parties have not engaged into a separate confidentiality agreement, the Term Sheet may include enforceable clauses requiring the Company to preserve the secrecy of information provided by the Company and perhaps the transaction’s negotiation.

Warrants

The Term Sheet will specify the sort of securities that the Investor intends to purchase, such as common stock, preferred stock, warrants, debt instruments, partnership interests, membership interests, or another form of security.

Early-stage enterprises often offer warrants to investors as a means of attracting capital. A warrant allows the holder to purchase shares in the firm at a later date or upon the fulfillment of specified criteria. While the investor is not required to exercise the warrant, the right does expire at a certain time—referred to as the expiry date.

If the Investor requires the Company to issue warrants in connection with the Investment, the Term Sheet should specify the following: 

1. The type of securities covered by the warrant;
2. The purchase price per share of the security covered by the warrant;
3. The warrant coverage percentage; and
4. The warrant term. 

Warrants gain value when the underlying shares’ value increases relative to the exercise price. Warrants may act as a “kicker” to boost an investment’s prospective economic worth. Although warrants are often issued in conjunction with bridge loans, they are comparatively uncommon in connection with preferred stock financings.

Need of Warrants

Warrants are considered as a bonus, since they enable investors to profit from the growth in share price while limiting negative risk. This is because the strike price is established when the warrant is issued. As a consequence, investors wait for the company’s stock to rise over the strike price. They can then purchase shares at lower cost than the current market value.

In general, early-stage firms often utilize this clause to augment equity or venture loan fundraise. In a warrant:

• Each holder will be entitled to a specified number of shares by the expiration date.
• Price at which the warrants are to be exercised is specified beforehand.
• It can be executed only within the mentioned time frame, after which it is invalid.  

Advantages of Warrants

Warrants benefit both the investors and the startup. A few major advantages are listed below:

• It increases the involvement of investors in the company’s development and improves the startups’ potential for profit
• There are no upfront charges – payment occurs only when the investor chooses to exercise the warrants.
• Reasonable pricing – warrants are typically priced at the market value of the underlying shares at the time of issue.
• Future cash flow – the investor is obligated to pay for the shares if the warrants are exercised.

Disadvantages of Warrants

Along with the many advantages of warrants, investors and startups can face significant downsides. A few prominent ones are listed below:

• Limited life: Warrants have a finite life, i.e. they must be exercised on or before their expiration date.
• Fall to zero: When warrants are exercised, their value might fall to zero, resulting in a loss equal to the investment’s whole worth.
• No control rights: Warrant holders do not enjoy the same level of control as shareholders.
• No dividends: Since warrant holders do not get dividends, they are unable to obtain dividends.
• Future dilution: This could result in a dilution of 1-2 percent if the holder exercises their warrants.
• Lower share price for startup: If the equity value of the share is more than the strike price at the time it is exercised, that part of the shares is acquired at a discount. This is a disadvantage to the startup.

How are Warrants priced?

Warrants have a strike price, which is the fixed price at which they may be acquired. The strike price is typically equal to the company’s stock’s fair market value on the day the warrant is issued.

The striking price may be determined in one of three ways:

1. Make use of a recent equity round’s value. Assume Company A just closed a Series A round of financing. The firm secured $20 million funding at $100 million valuation. To determine the striking price of warrants, the warrants would be valued at a $100 million equity valuation.
2. Come to an agreement on a negotiated price. If no previous equity round has occurred, the investor and firm might agree on a negotiated price.
3. Apply a discount on an upcoming increase. The last strategy is to price at a discount to the anticipated size of a future equity raising.

Conclusion

While warrants help to oil the wheels of finance, they may cause problems for the accounting of the corporation that issues them. One of the most difficult questions to answer is whether warrants are an asset or a liability. The exact terms and conditions included in warrants are the source of the misunderstanding. Despite the fact that warrants seem to have a set strike price, it is possible that the price is not fixed. Conditional changes may be made to the strike price or the number of warrants held in order to protect both the investor and the startup if specific criteria are met. These considerations influence whether warrants are recorded as a liability or equity on a company’s balance sheet, which can become more complicated based on the circumstances involved. 

In general, it is advised to avoid having too many conditions on the warrants. Instead, the startup can try to avoid the complications by giving more equity during initial investment, or any other advantage if possible. However, startups will have to choose the best option based on the expectations of investors and proceed accordingly.