Convertible note financings will oftentimes include an equity “kicker” structured as a warrant for the investors. This may be in lieu of a conversion discount on the notes and is intended to provide investors with extra compensation for taking the risk of investing early in the company. The trend these days in Silicon Valley and among seed accelerators is to use a conversion discount on the notes in lieu of warrant coverage, but warrants are still used in many parts of the country.
When warrants are included, we typically see “warrant coverage” in the range of 10 to 30%. “Warrant coverage” refers specifically to how big (i.e., how many shares) the warrant is, expressed as a percentage of the principal amount of the convertible note that the investor purchases in the convertible note and warrant financing. The warrant will allow the investor to purchase additional shares of the class and series of shares sold in the Qualified Financing.
If the investor purchased a $100,000 convertible note and had 25% “warrant coverage,” the investor would have a warrant to purchase an additional $25,000 worth of stock. How many shares that will be is determined at the time of the Qualified Financing. The exercise price per share in the warrant will be the price per share paid in the Qualified Financing.
Consider the following example: the investor invests $100,000 in a convertible note and warrant transaction with 25% warrant coverage. Interest on the note is 8% per annum, the Qualified Financing occurs 6 months after the convertible note and warrant financing, and the price per share in the Qualified Financing is $1.00. The convertible note investor would receive 100,000 shares for conversion of the principal of the note, 4,000 shares for conversion of the accrued but unpaid interest on the note, and a warrant for 25,000 shares, all for a grand total of upside on 129,000 shares. This compares to a similar investor investing $100,000 in the Qualified Financing and receiving 100,000 shares.
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