Negotiating Warrant Terms in Venture Financings

April 25, 2025  |  By

Warrants are a common feature in venture financings, providing investors with the right—but not the obligation—to purchase equity at a predetermined price, often as an incentive in connection with a financing transaction. While conceptually similar to stock options, warrants have distinct terms that can significantly impact both investors and founders. Understanding how warrants are structured is critical, as these terms influence an investor’s potential return, founder dilution, and the company’s long-term capitalization strategy.

Recipients of Warrants

In most venture financings, warrants are issued as non-compensatory instruments, meaning they are granted to investors, lenders, or strategic partners rather than as employee compensation. Unlike compensatory warrants, which are subject to different tax and regulatory rules, non-compensatory warrants function as investment incentives. Below are the most common recipients of warrants in venture financings:

  • Investors: Equity investors, particularly those in early-stage financing rounds, often receive warrants as an additional incentive to participate in a riskier investment. Some financings only provide warrants to investors purchasing a minimum amount of preferred stock, providing additional upside if the company performs well. Warrants are also frequently used to mask a down round because they provide additional dilution without necessarily lowering the valuation.
  • Lenders (Venture Debt Providers): Lenders in venture debt deals frequently receive warrants in addition to interest payments to compensate for the higher risk of lending to early-stage companies. These warrants provide the lender with potential equity upside while allowing the company to borrow non-dilutive capital in the short term.
  • Strategic Partners: Companies entering into joint ventures, licensing agreements, or other significant commercial partnerships may receive warrants as part of the transaction. This incentivizes the strategic partners to contribute resources, technology, or market access to the startup, aligning their interests with the company’s growth.

Key Terms and Structure

Warrants introduce several considerations that affect ownership, dilution, and control. For this reason, it is imperative that startup founders are well versed on the different terms (or levers) in a warrant. The following sections outline the key terms commonly negotiated in venture financings and their potential impact on both investors and founders.

1. Warrant Coverage

The most critical term is often the number of shares the holder receives upon exercise of the warrant. The number of shares underlying the warrant is typically determined by the following methods:

  • Coverage Ratio Method: The number of warrant shares is determined as a percentage of the investment amount (e.g., “20% coverage” means receiving warrants to purchase shares worth 20% of the principal investment).
  • Fixed Percentage Method: Instead of tying the number of warrants to the investment amount, some investors negotiate for a fixed percentage of the company’s fully diluted capitalization (e.g., 1% of the company’s fully diluted shares post-financing).
    • Impact on Founders and Investors: Similar to convertible instruments, the definition of fully diluted capitalization can be structured to favor either the founders or the investors. Investors may push for a broad definition that includes all outstanding options, warrants, and convertible securities, while founders may negotiate to exclude unissued option pool shares or specific convertible instruments to reduce the dilutive impact.

2. CLASS of STOCK

The class or series of stock underlying a warrant determines the rights and preferences associated with the shares upon exercise. Warrants are almost always exercisable into common stock and not preferred stock, most notably because the company would not want to pay any sort of liquidation preference for a security priced so low (see “penny warrants” below).

Warrants can, however, be issued for preferred stock, and this is frequently the case in distressed situations. And in turn, such warrant shares would typically include additional rights such as liquidation preferences and dividend participation.

  • Impact on Voting Thresholds: Warrants exercisable into preferred stock may affect the certain voting or approval thresholds set forth in the company’s charter or other financing documents. If the NVCA model documents are used, founders should note that certain protective provisions require approval from a majority or supermajority of preferred stockholders. If a warrant holder exercises their warrant into preferred stock, the holder may influence governance matters and investor control provisions.
  • Impact on Founders: Though dilutive, common stock warrants minimize complexity and align investor rights more closely with employees and founders, they can also prevent additional liquidation preference from being stacked ahead of common stockholders.

3. Exercise Price

The exercise price, or strike price, is the amount the warrant holder must pay to acquire each share upon exercise. The price is often set at the stock’s fair market value (FMV)  at the time of issuance, though it can be negotiated.

  • Penny Warrants: Some investors may negotiate for penny warrants, which have a nominal exercise price (e.g., $0.01 per share). While these can provide significant upside for the investor, they may also introduce tax and regulatory concerns for both parties.

4. Exercise Period (Term Length)

The exercise period is the duration for which the warrant remains exercisable. This gives the investor the opportunity to gather more information about the company (financial performance, market reaction, economic effect, etc.) before making an investment decision. In this respect, the information is asymmetrical, and provides the investor an advantage.

  • Impact on Founders and Investors: A shorter period (e.g., 3-5 years) minimizes long-term overhang on the cap table and can be favorable to founders. Additionally, if the investor is going to pay cash to exercise the warrant, then the company would like the cash sooner than later. Conversely, a longer exercise period (e.g., 10 years) provides investors more flexibility and can serve to derisk their investment.
  • Methods of Exercise: Warrants can be fully or partially exercised by paying the exercise price in cash or through a cashless exercise mechanism. In a cashless exercise, the investor receives fewer shares but avoids the need to provide cash at the time of purchase.
  • Practical Impact on Cap Table: While fixed percentage warrants can remain outstanding until exercise or expiration, they can also frustrate future financing rounds. Lead investors will often negotiate or require any outstanding fixed percentage warrants to be exercised, in order to prevent subsequent dilution after the financing.

5. Vesting vs. Immediate Issuance

Warrants can be immediately exercisable upon issuance or subject to a vesting schedule. Vesting schedules are commonly used when warrants are provided as incentives to strategic partners or investors committing to future performance milestones.

  • Acceleration: The treatment of unvested warrants in the event of a change of control (such as an acquisition or IPO) can significantly impact their value. Some agreements provide for automatic acceleration, allowing the warrant holder to exercise all vested and unvested warrant shares prior to a liquidity event.

6. Additional Rights

Beyond the core economic terms, some warrants include other rights that can provide investors significant additional protection and can materially affect a company’s capitalization. While not always standard, provisions such as anti-dilution protection and preemptive rights can influence how warrant holders navigate future financings and ownership dilution. These rights can be particularly relevant in down rounds and follow-on investments, where maintaining proportional ownership is a priority.

Conclusion

Each term in a warrant involves trade-offs—while investors seek additional upside, founders must balance dilution and control considerations. Check out our other resources to learn more about founder and investor considerations in venture financings.

Posted in: Funding & Capital Raising

About the Author(s)

Bobby Gojuangco

Bobby Gojuangco is an attorney at Vela Wood. He focuses his practice in the areas of venture financing, M&A, and taxation.

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