Leveraging Equity Incentive Structures for Third-Party Relationships: A Warrant-ed Alternative Security Structure for Angels and Advisors?

By: Jennifer Kay

Startup founders are typically willing to offer straight equity, in the form of preferred or common stock, to angel investors and advisers who agree to commit their capital or time to the venture. That said, founders often feel that they must offer a significant proportion of equity to early-stage contributors who may or may not be committed to actively contributing to the company’s long-term success. To incentivize early-stage contributors’ long-term commitment to their company’s growth, founders should consider offering stock purchase warrants, instead of or in addition to straight equity, to angels and advisers. That said, founders should beware that issuing warrants may complicate their accounting and flexibility in later financing rounds.

Not to be confused with search warrants, stock purchase warrants are financial instruments that provide holders with the contractual right to buy a certain number of a company’s equity shares directly from the company a fixed price during a defined time period. Accordingly, warrants are similar to employee stock options, as both provide the contractual right to later purchase an equity security. That said, employee stock options are only available to intra-company parties (i.e., the company’s officers), while warrants are available to parties external to a company (i.e., angel investors or advisers deemed to be independent contractors of the company). Additionally, while companies that issue employee stock options typically do so under universal terms for all employees, companies that issue warrants typically do so in the context of third-party transactions (i.e., in exchange for an investment) and the terms of warrant contracts are typically negotiated deal-by-deal.

As startup founders consider various financing structures for their venture, they should consider incorporating warrants into the toolbox of financial instruments that they use as consideration for angel investors or advisers. Specifically, founders should consider offering warrants to angels or advisers in order to incentivize early investment as the exercise price of early-stage warrants would likely be significantly lower than later share value. In this scenario, if the stock value goes at least as high as a warrant’s exercise price before the expiry date, the warrant is “in the money” and the warrant-holder may purchase commensurate shares. Thereafter, if the future stock value exceeds the warrant’s exercise price, the warrant-holder may want to purchase the stock and then immediately resell the shares at a profit or hold the equity until a later acquisition.

Founders should also consider issuing warrants as a means of compensating external parties like angels or advisers for bringing in new business to the company (i.e., by setting performance-based milestones as the trigger for warrant exercisability). That said, warrants received as compensation for performing services will be taxed just like compensatory employee stock options (see http://www.thetaxadviser.com/issues/2014/sep/tax-clinic-10.html http://www.thetaxadviser.com/issues/2014/sep/tax-clinic-10.html).

Further, if a startup wants to avoid having to register their securities with the SEC, the startup will have to ensure that warrants granted as compensation for advisors meet the requirements of SEC Rule 701, thus further complicating warrant-based consideration structures (see https://www.pillsburylaw.com/images/content/4/8/v2/483/RobbinsRule7012013.pdf: Adopted under Section 3(b) of the Securities Act of 1933, Rule 701 provides an exemption from the registration requirements of the Securities Act for certain offers and sales of securities made pursuant to the terms of compensatory benefit plans or written contracts relating to compensation by an issuer that is not subject to the reporting requirements of Section 13 or Section 15(d) of the Securities Exchange Act of 1934 and is not an investment company registered or required to be registered under the Investment Company Act of 1940.)

In addition to the tax and securities law-related complications associated with warrants, the lack of shareholder voting rights associated with warrants may prompt angels or advisers to resist warrant-oriented consideration for their capital or time.

Accordingly, founders should understand, and weigh the benefits and drawbacks of, warrants as they structure angel and adviser equity grants. While warrants may provide a way to incentivize angels’ and advisers’ long-term commitment to a company, warrants may also provide accounting, tax, and securities law complications for both companies and warrant-recipients.