Many Golden Returns

Entrepreneur, March, 2000 by David R. Evanson, Art Beroff

Warrants promise investors great stock prices in the future--and can get you cash now.

The failure rate for new businesses is high. But in truth, most new enterprises don't fail because they can't generate enough business--they fail because they just plain run out of money. When, for instance, you're pouring more and more capital into inventory and selling to new markets, it doesn't matter that your existing clients are paying their bills on time. The fact is you can't sell your way out, and to keep the show going, you need an outside infusion of cash.

The two corollaries to this hard truth are as follows: First, no matter how badly you need this outside capital, it will be expensive and difficult to entice investors to put money into your risky venture. Second, you will not be able to reach your goal with a singular outside investment. Raising money begets the need to raise more money.

These realities lead to a maneuver that should be in the corporate-financing playbook of every entrepreneur: warrants.

A CLOSER LOOK

In a jargon-filled world of straight equity, subordinated debt, sweat equity, term loans and lines of credit, what the heck is a warrant anyway? In definitional terms, the warrant gives its holder the right to purchase a share of stock at a future point in time, for a specified price. Most importantly, warrants serve an almost perfect duality of purpose: They entice investors with the promise of future riches if things work out, and they put into place a fairly reliable future influx of capital if you meet those expectations.

Here's how a hypothetical entrepreneur might use warrants to bring in investment dollars and make sure they keep coming once the business takes off. Assume the following scenario: An early-stage growth company in the communications technology industry with $1 million in revenue is seeking $1 million in capital. Further assume that similar, early-stage communications tech companies are being valued at three times their revenues, meaning our hypothetical enterprise is worth $3 million. As a result, for the $1 million our entrepreneur needs, he or she is willing to give up about one-third of the company ($1 million investment/$3 million valuation).

Finally, assume the entrepreneur runs into the kinds of resistance from investors that typify the plight of all entrepreneurs trying to raise capital:

* Your management team is incomplete at the time of the deal.

* There is uncertainty about your company's ability to successfully develop the product.

* Even if you are able to develop the product, there is no pool of established customers with a track record of paying for the product.

* You are too small to have much power in distribution channels.

* There are no significant barriers to entry, and anyone can come in and eat your company for lunch.

To help investors with the many challenges they've conjured up in their minds, our entrepreneur might make the following offer: 'If you buy one million shares from me at $1 each, I will give you the right to purchase more shares for a price of $2 apiece for a period of three years.' That offer, technically speaking, is called a warrant.

From this rather pedestrian definition, it's hard to see how warrants offer much incentive at all. But consider this: Would you like to be holding a security today that gives you the right to buy several thousand, or several hundred thousand, shares of online giant America Online for mere pennies per share? With today's market as it is, that offer sounds great. But when the Net companies weren't the hot stocks they are today, such a ploy might have been required to get cagey investors off the Fence. And that, in a nutshell, is the sweet spot for investors. Specifically, through warrants, they can cash out big, really big, if their warrant is attached to the next big thing.

Now let's assume our entrepreneur works magic with the investors' $1 million, and at the end of two years has ramped up sales to $5 million. Now our hypothetical venture is valued at $15 million, and each of the three million shares outstanding are worth $5 ($15 million/three million shares). Meanwhile, our lucky investors have an option to purchase shares for $2. If the investors exercise their warrants to purchase one million shares at $2, the company will raise $2 million. And since investors are buying stock worth $5 for only $2, they will earn (but probably not realize) a gain of 150 percent.

FIRE WHEN READY

Truth be told, in our example, it's unlikely the investors have gotten any less cagey or any more confident in the intervening two years, even though the company has performed. Sure, they can buy $5 stock for $2, but only in theory, unless it's a public company. As a result, most warrants have some kind of mechanism allowing the entrepreneur to pull the trigger, so to speak, and get the investors to exercise their option to buy more shares.

This trigger mechanism is often called a "redemption feature," and it works like this. In addition to giving investors the right to purchase additional shares, warrants offer the company the right to buy the warrants back from the investors, often for just a few cents. So in the case of our hypothetical venture, here's how it might play out.