I have never had any direct exposure to venture debt, but have always understood that there is a component of the structure that features warrants to juice the lender's returns and compensate for risk. With the SVB news lately, I really want to finally understand the mechanics of this feature. I've read through a lot of these warrant agreements on EDGAR but am unclear as to how the lender actually realizes this gain.
Using this hypothetical (constructed based on my understanding of how it works), can someone narrate exactly how/when the lender would exercise warrants and realize this gain?
Deal Example
- Loan Amount: $10MM
- Warrant Coverage: 10%
- Warrant Price: Same value per share from last funding round (say, $10/share)
- Loan Maturity/Warrant expiration: 5 years
- Debt structure: Interest only, 10% fixed rate (assume fixed for ease of example)
Analysis
- To realize the value, does the Lender actually exercise the warrants? Would they ever just sell them to existing investors?
- Once they exercise the warrants, how do they realize any gain on the value? Are these shared sold during the next funding round? Would the lender hang on to them into future funding rounds for higher gain?
- Do lenders that exercise warrants really have a bunch of minority interest sitting on their balance sheet and some portion of their P&L associated with gains/losses on shares acquired via warrants?
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After speaking with an equity warrant manager, I can somewhat provide some detail.
Yes, the lender can exercise the warrants, usually if they are deep ITM. Depends on the situation and outlook, but in the case of an IPO, they would offer the shares they received from exercising the warrants. PM's may not hold the equity given the risk.
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