Warrants or Convertible Notes: Which Costs You More Equity

A warrant gives the lender the right to buy a set number of shares later at a strike price fixed today, usually your last round's price. Coverage is expressed as a percentage of the loan amount, and that percentage times the strike price sets the share count. The mechanics look small on the term sheet but compound at the next financing, because the option sits outstanding on a fully diluted basis whether or not the lender ever exercises it.

Ask whether coverage is calculated on the committed facility or only on amounts actually drawn. A facility with a large undrawn tranche and coverage on the full commitment dilutes you for capital you may never use.

Some lenders, especially on smaller or earlier stage facilities, ask for a small note alongside the loan instead of, or in addition to, warrants. Unlike the warrant's fixed strike, a note usually converts at whatever price your next qualified round sets, often with its own discount or cap layered on top. That means the lender's eventual ownership isn't fixed at signing the way a warrant's is. It moves with your valuation, and a down round can hand the lender more shares than a warrant ever would have.

Say you're raising a two million dollar venture debt facility and the lender wants either five percent warrant coverage at your last round price, or a fifty thousand dollar note convertible at the next round with a twenty percent discount. If your next round prices well above your last one, the fixed-strike warrant is cheaper for you. If the next round is flat or down, the note's discount can end up handing over more of the company than the warrant would have. Neither answer is right in every deal. The point is to model both against a range of next round outcomes, not just the one you expect.

A simple decision rule follows from this. If you expect your next round to price well above your last one, favor the fixed-strike warrant and negotiate the coverage and exercise window. If you expect a flat or down round, or you cannot say, treat the note's discount and cap as the bigger risk and push for the lowest coverage on any warrants that come with it. Before choosing, ask your counsel to run each structure through a cap table model at three next-round outcomes, up, flat and down, and compare the ownership the lender ends up with in each case.

Three terms do most of the work: the strike price basis (last round versus a fixed dollar price), the coverage percentage, and the exercise window (some warrants expire in five years, others last for the life of the company). A shorter exercise window and a strike tied to your next priced round, not your last one, both push dilution down. If a note is involved, push on the discount and whether it has its own cap, since a note with both a low cap and a steep discount is effectively two ways to lose equity on the same instrument.

Push on these terms before you sign:

• Ask whether warrant coverage is calculated on the committed facility or only on the amounts you actually draw.
• Tie the strike price to your next priced round instead of your last one where the lender will agree.
• Shorten the exercise window, since some warrants expire in five years and others last for the life of the company.
• If a note is involved, negotiate the discount and check whether it also carries a cap.
• Check whether the warrant has its own anti-dilution protection that could reset the strike price after a down round.

The most common mistake is treating warrant coverage as a rounding error because the dollar figure the lender quotes looks small next to the loan itself. The dollar figure is the strike price times a share count, not the value of the dilution, and the value moves with your company's growth, exactly the growth the loan was meant to fund. The second common mistake is not reading whether the warrant has anti-dilution protection of its own, which can reset the strike price down if you later raise at a lower valuation, stacking dilution on top of dilution.