If raising money were easy, everyone would do it. The irony is lots of companies with great ideas die on the vine. Often, it’s money that’s the root cause. But we have to consider other things like timing, human resources, and messaging, just to name a few. Too many times, we see a solution in looking at a problem.
Our job is to sort through companies and identify those who we believe can avoid failure.
It’s not easy. We need to be rewarded for our risks because no matter how great a company may appear on paper, it could die on the vine. The money vine.
So, we search for opportunities that could offer an asymmetrical reward versus risk. That means we believe the upside potential could be many multiples compared to the capital risk.
Unfortunately, some businesses don’t have that style of upside. Does that mean we walk away?
No. Absolutely not.
Because then companies raising money can still construct an offering that potentially benefits the business and transforms a balanced risk-reward into an asymmetric opportunity.
They can do this with a carrot of sorts.
I’m not sure why we refer to a carrot as enticing. Why not chocolate? Or whiskey?
Anyhow, I digress.
This whiskey chocolate carrot is better known as a warrant.
A warrant is the same thing as a call option. It provides the holder of the warrant the right to buy shares of a company for a set price for a set period.
Why is this good for a company?
First, it may make their shares more appealing, thus helping them raise more capital.
Second, it can act as a future capital raise already built-in from day one.
Third, there is a chance the warrants will expire worthless, and the company would have no future obligations to those warrants, providing some possible capital flexibility in the future.
Why is this good for an investor?
Leverage.
Too often hear the word leverage and think of it as a dirty word, but what if you could get additional upside potential on a stock without risking any additional capital?
That’s how leverage works here if you are awarded a warrant for no additional upfront investment. Additionally, if the stock goes down, you don’t owe anything on your warrant.
The only way to lose is to either exercise your warrant at a higher price than the stock (you should likely never do this) or exercise the warrant, hold the newly purchased stock, and then watch the stock move lower.
Investors benefit along with the company if the company is successful raising money. The company most likely needs the money to succeed and success is good for the investor as well.
Let’s look at an example:
Company A is offering shares at $1.00 each at a $10 million valuation. For every share you purchase, you also receive a warrant to buy additional shares at $2.00 each for the next three years.
If the stock stays at $1.00 for the next three years, your investment is worth the same.
If the stock drops to $0.50, you’ll be down half your investment.
If the stock rises to $2.00, your investment will be up 100%.
But here’s the kicker, if the stock rises to $3.00 in the next three years, your initial investment will be up 300%, not 200%. The stock rose by $2.00 but you also have a warrant that is worth $1.00 per share ($3.00 stock price less than $2.00 cost to exercise the warrant).
The warrant doesn’t change your downside but it does increase your upside. That’s leverage we like.
And if you exercise those warrants, the company has now raised additional capital at more than twice their first pre-money raise.
This is something we prefer to see from deals as it offers many potential benefits without significant drawbacks.
