Financing for startups has never been easy. If investors are going to finance an early-stage company, they want to cover the extra risk that comes with a shorter track record. The market has responded with creative ways to sweeten the deal for investors during a capital raise. One common approach is to issue warrants. Yet as helpful as warrants are, the way companies classify them in their accounting can cause mammoth downstream issues.
What is a warrant?
Warrants are often issued by early-stage companies to investors as an incentive to attract investors. A warrant gives the investor the right to buy stock in the company at a later point or when certain conditions are met. The investor doesn't have to exercise the warrant, but the right does expire at a specified point—known as the expiration date.
Warrants are often seen as a sweetener because they allow the investor to take advantage of price increases, with limited downside risk. This is due to the strike price, or exercise price, being fixed when the warrant is issued. As a result, investors wait for the underlying stock of the company to increase past the strike price. They can then buy stock at a discount.
Companies issue warrants for many reasons. However, early-stage companies often use them to supplement a capital raise: for investors buying equity or for lenders providing venture debt. They are used across many industries in Canada, particularly in tech and mining.
Equity vs. liability: Why warrants create issues on a company's books
While warrants grease the wheels of Canadian finance, they create issues for the issuing company's accounting. The problem hinges on a fundamental question: Are warrants equity or liability?
It is the detailed terms and conditions in warrants that cause the confusion. Although warrants may appear to have a fixed strike price, it may not actually be fixed. To protect both the investor and the company, terms and conditions may change the strike price or number of warrants held if certain conditions arise. These factors impact whether warrants appear as liability or equity on the balance sheet, and the conditions are only becoming more and more complex.
Because companies issuing a warrant don't always know whether it is an equity or a liability, they often classify it incorrectly: as equity when it's actually a liability, or vice versa.
Debt covenants: The downstream impact of warrants
The problem is that the question of equity vs. liability touches many of the other financing relationships forged by the company. At the top of this list are debt covenants.
Debt covenant agreements are initiated by lenders to protect themselves when loaning money. They want to ensure that the borrower can repay the money. If the borrower takes on too much additional debt, the odds of repayment decrease.
Although warrants typically don't require cash payments, they may be classified as liabilities. Many lenders modify covenants to ensure non-cash liabilities such as warrants are excluded from covenant calculations. If the company categorized the warrant as equity when in fact it is a liability, they will not know to have discussions with their other lenders to modify covenants. Consequences of violating the covenant vary, but they often require the borrower to repay the entire amount owing immediately and, as a result, also put its financial health at risk.
The same happens with debt covenants signed in the future. A company may have already issued a warrant and mistakenly categorized it as equity. Then it borrows more money and agrees in a new covenant to keep its liabilities below a certain ratio. Meanwhile, it has already violated the terms of the covenant—because the warrants it issued are in fact liabilities.
Solve the accounting issue before it starts
Warrants are not the most complex financing mechanism startup companies use. Perhaps that's why they provide such an effective lesson for companies closing their next deal. If even mistakes with warrants—complex but not extraordinarily so—create accounting issues for companies, more complicated instruments certainly cause problems.
Companies can prevent surprises by reaching out to their accounting advisor before finalizing a deal. The accounting advisor guides the company on the accounting implications as they negotiate the financing. The changes they recommend may be subtle, but they could make a world of difference at year-end—or the next time the company reviews its debt covenants.