The primary motivation for growth stage companies to explore venture debt as a source of funding is to avoid the dilution that results from a round of equity financing. While venture debt will certainly be much less dilutive than an equity raise, prospective borrowers may be dismayed to learn that almost all venture loans come with a warrant feature attached. Research suggests upwards of 73% of loans include warrant coverage1, which is a lesser percentage than we would estimate based on real-world market experience.
Borrowers understandably question why lenders require equity warrants in connection with what is intended to be a non-dilutive debt financing. In addressing this valid concern, it is important to note that what may seemingly appear to be an additional cost to the loan that only enriches the lender, is actually a feature that benefits the borrower in often overlooked ways. Although a relatively minor piece of a standard venture loan package, warrants play an important role for both the lender and the borrower.
No single explanation for incorporating warrants with venture debt exists and the various rationales for inclusion are interrelated. While each explanation is perhaps valid in its own right, reality suggests a likely combination of factors are at play. In this piece, we will explore two of the more predominant empirical explanations along with two more practical reasons.
In the literature, two explanations have been posited for the prevalence of warrants in conjunction with venture loans. First, warrants more closely align lender and borrower incentives by promoting continuity rather than foreclosure1. Second, gains from warrants offset losses from loans and therefore help lenders achieve portfolio-wide blended targeted returns2. Practitioners would likely agree with the literature while adding that warrants allow them to participate in upside value creation while keeping borrowers’ cash burden at reasonable levels.
Warrants Align Lender and Borrower Incentives
Earlier stage companies in the innovation economy tend to have very little collateral by way of hard assets. Instead, the primary collateral underpinning venture loans is intellectual property consisting mainly of patents and trademarks. Research shows that borrowers with larger intellectual property portfolios grant larger warrant coverage, both in absolute amounts and as a fraction of loan amount1.
It is believed that warrant coverage mitigates opportunistic foreclosure against the intellectual property collateral that represents the firm’s core assets. While intellectual property may have inherent value that is severable and transferrable, its value is typically maximized when utilized as part of a going concern. Therefore, lenders seeking to preserve collateral value should want a borrower to stay as a going concern and avoid taking actions that would inhibit the ability to remain fully operational. In this way, warrant coverage aligns the incentives of the lender with those of the borrower and equity investors by granting the lender a stake in the continued existence of the company.
Gains from Warrants Offset Portfolio-Level Losses
Every lender views warrants through a slightly different lens, but publicly disclosed comments from Business Development Companies (BDC’s) and empirical research suggests that warrants in successful start-ups compensate for defaults in non-successful start-ups2. Said differently, venture lenders are targeting a certain portfolio-wide blended return on their capital, which is achieved primarily through the contractual economics provided by debt instruments. However, losses are inevitable when lending to earlier-stage companies and in order to achieve overall targeted returns throughout credit cycles, lenders look to their warrant holdings to offset losses elsewhere in their loan book.
Warrant Returns Keep Debt Payments Manageable
Traditional bank loans are extended to well-established businesses with a history of generating sufficient cash flows to repay their debt. Conversely, venture loans are originated to earlier stage companies in growth mode, which requires investment in the business. Investing in the business tends to consume more cash than is generated by operations. In cash flow negative scenarios, cash in king and interest paid on the loan is withdrawing cash from the business when it is needed most. Therefore, finding ways to minimize the coupon rate to preserve cash in the business is ideal for the borrower and warrants enable just that.
Venture debt is markedly riskier than other forms of lending which necessarily requires a higher return. Addressing elevated risk strictly through charging an appropriate risk-adjusted interest rate would consume too much of a young company’s precious cash. Warrant inclusion seeks to true up the risk/return associated with venture debt while keeping debt payments manageable.
Warrants Allow Lenders to Participate in the Upside
Venture lenders often provide growth capital at times when an equity investment would be meaningfully dilutive to existing equity investors. Growth capital in the form of debt is invested in high return on capital areas of the borrowers business which in turn generates value for the owners. For enabling this dual benefit of lower dilution and growth capital, lenders seek to participate to a relatively small degree in the value that is created from the capital they provide.
Like other venture lenders, and for the reasons outlined above, SWK also requires warrants with most of our loan financings. However, SWK differentiates itself by our ability to construct creative solutions that allow us to achieve a certain risk-adjusted return while keeping ongoing interest payments at a minimum. We welcome borrowers concerned about dilution to inquire about alternative structures.
- González-Uribe, J. & Mann, W. 2017. “New evidence on venture loans*” LBS PE Symposium. https://www.dropbox.com/s/5l9xntjdzrs1xbg/LBS_PE_symposium.pdf
- Ibrahim, D. 2010. “Debt as venture capital.” University of Illinois Law Review, 2010, 1169–1210.