In this video, you'll learn how stock warrants dilution becomes dilutive for a startup.

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Warrants are kind of like another form of stock options, except for stock options, you give them to the employees of the company. For warrants, you're actually giving them to someone who's like a business relationship. So a good example might be like a key customer who kind of like makes your company by signing up and paying you money and endorsing your technology for use. Or maybe like a venture debt deal, you know, someone who's giving you debt, charges you interest, but they also charge you some extra warrants in the form of equity which gives them an equity return. Sometimes even investors, if they do like a bridge round or something like that, something uncomfortable for them, they'll ask for some extra warrants.

And so you could imagine like that customer, or lender, or investor who gets additional warrants in the company at like Series A, maybe the valuation's like $25 million or something like that. Six years, seven years from now, the company does an IPO at a billion dollar valuation.

Well, that's basically a 40X. It's not a true 40X return because they have to exercise the warrants, pay to have the shares, and there's probably been some dilution on the way, but you could kind of see the thought experiment here. So those warrants become valuable, quite valuable, actually. In fact, the venture debt industry, part of the whole business model is built on getting these warrants, and so everyone kind of knows these things are valuable. Now, remember it's dilutive because you've actually issued the right to purchase those shares. But there is one good thing for the company in that the owner of the warrants has to issue, basically pay cash, to the company to actually own those shares outright. So in my example, the $25 million valuation, maybe the strike price of those warrants is $1 a share, just to pick a super round number. But when the company goes public, it's $40 per share.

Well, the owner of the warrants will either write the company a check for $1 times the number of shares in that warrant. And so the company is recouping, in this case it's not great, they're recouping kind of like 2.5% of the value of those warrants because that's a 40X return, but they're getting something. Oftentimes, the owners or holders of a warrant will also just do what's called a net exercise, which is if they own just a bunch of shares, call it like, to make the math easy 10,000 shares. And, in this case, they might send back 2,500 shares, again, 2.5% of the total back to the company, instead of sending cash back, they just send back, you know, basically enough shares so that the value of that exercise requirement is covered.

And so either way, the company is getting some compensation back in the form of the exercise price. The holders of the warrant is getting a lot of shares, which unfortunately for the company, is dilution. That's ownership that they gave to a third-party that the company or the existing shareholders did not own at the time of the IPO. Now you might say, "Well, why would anyone ever give warrants up or why would they want to dilute themselves?" Well, it's kind of like fundraising preferred shares from VCs. Like you need capital or you need this business arrangement that's going to happen. You know that it will materially help or improve the valuation of the company and get you on your journey to that destination of an IPO, and so you're willing to do it. You know, you sell shares in your Series A, your Series B, your Series C to venture capital investors and don't really think twice about it because you need that capital.

Same thing happens in the debt deals or with those important customers. So warrants, like stock options, are dilutive, but you do get to mitigate that dilution a little bit with the exercise price.