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Basics of Warrant Coverage Terms - Regulation D and PPM Lawyers

Basics of Warrant Coverage Terms

by / Monday, 06 March 2017 / Published in Raising Capital, Regulation D
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In order to induce “investment” of valuable dollars or services, ranging from cash investment under a Regulation D Private Placement Offering, or on the flipside, the efforts of a trusted advisor/accelerator/incubator, so-called “warrant coverage” is often part of the deal. “Warrant Coverage” is designed to further persuade an investor or service provider to participate in an investment opportunity by providing the investor or service provider additional opportunity to leverage the company upside, as it grows in value. While less commonly used than a variety of other deal “sweeteners”, they are a significant feature in the investment landscape. The following provides a high-level summary of the typical negotiated deal points for warrants.

Number of Warrants/Class of Warrants The amount of equity to be granted pursuant to the exercise. For most service providers, the amount of the warrant grant is a function of the proposed valuation target company, vis-à-vis the value of the services provided by vendor.
Exercise Price Determining the exercise price needs to be based on as defensible a valuation as possible. Under US tax Rule 409A, there can be severe consequences for failing to set an exercise price based on the “fair market value” of the warrant at the time of grant (in other words, the warrant exercise price, at the time of grant is below market value).
Cashless Exercise Commonly, warrants provide for a simultaneous mode of exercise that doesn’t involve the actual expenditure of cash. The so-called “cashless exercise” provisions basically said that the warrant holder gets to use the INCREASE in value of the shares from the original stock exercise price to purchase the stock WITHOUT actually spending cash. Often, this is used not only to provide an opportunity for the service provider not to actually expend cash, but to also further align the interests of the service provider and the target company towards increasing the value of the target company.
Duration and Expiration Typically, warrant grants do not run in perpetuity. Rather, they run for a predefined set of years, within which the recipient has the ability to exercise (or not exercise) the warrants. Classically, the time ranges of 3, 5, and 10 years are employed.
Vesting Like options, warrants can also be made to vest for purposes of aligning the interests of the target company and service provider. Ultimately, once an award vests, it can then be exercised (but always subject to the overall duration and/or expiration of the warrant as discussed above).
Allocation of Exercise Shares For purposes of predictability and transparency, a common negotiation point is whether or not the capitalization table for the target company has already pre-allocated shares for purchase by and through the warrants. As a result of such pre-allocation, further dilution of the other equity stakeholders can be averted and further (sometimes complicated) issuance of shares to satisfy the warrant exercise can be averted.
Acceleration of Vesting If there is a vesting schedule, commonly it is paired with a so-called “Acceleration Provision” that automatically vests the unvested portion of the warrant grant, upon a so-called “Change of Control” (i.e., the target company is sold, merged, etc.).
Market Standstill A so-called market standstill provision is essentially a standard provision that states if the target company goes public, and the warrants are exercised, the shares that are purchased cannot be sold for 180 days prior to the IPO.

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