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Test Case: Warrants on Preferred Shares vs. Options on Common Shares

Many startups at the stage of raising capital from large investors issue preferred shares with warrants on the same share class. Recent market data shows that in the last few years, a large majority of preferred shares are non-participating preferred (CAP X1). With this type of share class and the company value reflecting conversion to common shares, the company and their investors might view the warrants as options on common shares. This however is a misconception, and in this post we’ll explain why.

Two Example Scenarios

Let’s assume a company is raising $2 million ($2 per share) from a Series A non-participating preferred share. In the first scenario, the company offers the Series A investors an additional one million warrants, with an exercise price equal to the issue price of the preferred share.  In the second scenario, the company offers investors one million options on common shares with the same exercise price.

Scenario 1: The investors decide to invest with the additional one million warrants. The table below illustrates the post-Series A company cap table:

table 1

The breakpoint calculation in which the Series A (including the warrants) non-participating preferred share will convert into common shares is the following:

2/3 * (X + 2 – 2) = 2 + (2 – 2) => X = $3M      (The (2 – 2) reflects the net cash from the warrants).

With a company value of $4 million, the Series A preferred shares and warrants will convert to common shares with a total net proceed of $2.667M (see the waterfall below).

Graph1

Scenario 2: The investors decide to invest with the additional  one million options. The table below illustrates the company’s post-Series A cap table and option plan:

table 2

table 3

According to the breakpoint calculation, the Series A non-participating preferred share and the options will convert into common shares at the same company value:

1/3 * (X + 2 ) = 2  => X = $4M

With a company value of $4 million, the Series A preferred shares and the options will receive a total net proceed of $2 million (the net proceed of the options will be zero since this is the exact company value in which they get “in the money”).

Graph2

Graph3

Conclusion

As you can see from the examples above, warrants on preferred shares are not equivalent to options on common shares with the same exercise price – even if the company value reflects a full conversion to common shares. It is important to understand legal economic rights, such as non-participating preferred, and how they may affect the outcome of 409A and ASC 820 projects. AlgoValue can help startups and investors navigate these challenges, by simulating their negotiation term sheets, and enabling them to be better prepared for handling the complexities that come with capital raising today.

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