As startups strive to thrive in the competitive business landscape, they often require creative financing options to fuel their growth. One such instrument that has gained popularity is warrants. In this article, we will delve into the world of warrants, exploring their legal significance for startups.

What are Warrants?

Warrants are a derivative right that grant the right to buy or sell a security – most commonly a share – at a certain price before or on the expiration date. Essentially, warrants act as a powerful tool to attract investors by offering them the potential to participate in the company’s future growth.

How do Warrants work?

1. Company XYZ issues bonds with attached warrants. Each bond includes the right to purchase 50 shares of the company’s stock at a predetermined price of $10 per share within a ten-year period. This predetermined price is known as the strike price.
2. Suppose, within five years, the market price of the company’s stock rises to $20 per share, and the holder decides to exercise the warrants. 
3. By doing so, the holder can buy 50 shares of the company’s stock at $10 per share instead of the current market price of $20 per share, resulting in a profit of $10 per share.

The Legal Framework

From a legal standpoint, warrants must be carefully structured to ensure compliance with regulatory authorities. Issuing warrants involves drafting detailed agreements that outline the terms and conditions of the warrant, including exercise price, expiration date, and any other relevant provisions. This requires the expertise of legal professionals who specialize in securities and corporate law, to ensure that the warrants are fully compliant with applicable regulations.

Advantages for the Startups’ Founders

Warrants offer several advantages to startups seeking funding:

1. Attracts Funding Even if the Company’s Value is Not Fully Clear Yet: Startups often find it hard to determine how much their business is worth when they are just starting. Investors might be willing to invest at a lower price initially because they have the chance to buy the shares cheaper than the market price when the company succeeds later on.
2. Preserving Ownership of the Founders: Startups can get funding without immediately giving away more ownership to new investors. It helps keep the existing owners’ control of the company intact.
3. No Immediate Incurring Debt: Compared to other financing methods that facilitate shares ownership such as convertible notes. Warrant allows Startups to raise capital without incurring immediate debt or interest, making it a lower-cost form of financing compared to convertible notes, which give rise to interest and principal debt. In fact, If the warrants are not exercised, there is no repayment required.

Advantages for the Investors

1. Encourage a “Wait and See” Approach of Investing: Investors are able to choose whether or not to exercise the warrants. This limited commitment allows investors to choose to wait and observe the startup’s performance before making a decision, whether it exceeds expectations or falls short of them. If it falls short, then investors can simply choose to not exercise the warrants.  Investors need not fear risking a significant amount of capital or incurring substantial losses.
2. Exposure to High-Growth Potential: Warrants are commonly associated with startup companies or those in the early stages of growth. By investing in warrants of such companies, investors gain exposure to potentially high-growth opportunities. If the company’s stock value increases significantly, warrant holders can capitalize on the growth at a relatively lower cost.
3. Low-Cost: Investors do not need to provide any loan when concluding a warrant agreement, in contrast with other investment instruments such as convertible notes where the note holder has to provide a loan to the note issuer. Investors only need to pay a relatively small upfront amount, known as the warrant premium, to purchase the warrants and hence “locking” the right to buy the shares in the future with a strike price. 

Real Life Examples

1. In 2014, JPMorgan obtained warrants from Tesla. When the warrants reached the maturity date, Tesla was required to pay JPMorgan either in shares or cash if the price of Tesla’s stock was higher than a particular strike cost.
2. In 2017, car manufacturer Peugeot S.A. issued warrants that were bought by General Motors Holding LLC. The right to buy shares was executed on 15 September 2022. 

Conclusion

In conclusion, warrants are a derivative right that grants the right to buy or sell shares at a certain price, it helps startups attract funding even when the company’s value is not fully determined and without the need to pay any debt if the warrant is not exercised. 

However, it is crucial to engage legal experts to navigate the intricacies of warrant issuance successfully. By leveraging warrants wisely, startups can secure the necessary funding to propel their growth, while investors can potentially benefit from the company’s flourishing success in the future. If your startup is considering issuing warrants or investing through buying warrants, you may reach out to our experienced legal team for expert guidance tailored to your specific needs.

This constitutes merely our initial review of the use of warrants for startups and must not be treated as our legal opinion. Any use of this other than for your internal or personal reference, is prohibited, unless a prior written consent has been obtained from us.

Should you have any questions, feel free to contact us through:

Sunny Sabaru (Founding Partner): ssabaru@rspstrategic.com 

Graceyana Jennifer (Associate): gjennifer@rspstrategic.com 

Agenda Citra (Associate): gmuhammad@rspstrategic.com