Making the most of Performance-based Warrants

By Biplab Adhya and Venu Pemmaraju, Managing Partners at Wipro Ventures

Over the last few years we’ve seen a significant increase in the number of corporate venture capital funds and other strategic investment groups. Along with the rise of these types of investors, the use of Warrants as an investment vehicle has also risen in prominence. While Warrants are less widely understood than traditional equity stakes, they can be an effective way to align incentives between a startup and its strategic investors. Entrepreneurs building enterprise focused startups should understand how to leverage Warrants to align incentives and drive more effective partnerships.

In this post, we’ll explore the ins and outs of this instrument as it relates to startups, venture capital, and strategic partnerships.

Background

Warrants are like options in that they give their holders the right to buy shares at a pre-negotiated price, and once exercised, grant the warrant holder equity in a business. Warrants can be designed to vest over time, but in our experience, they are best utilized when linked to a performance-based trigger or other specific milestones.

Why Performance-based Warrants?

Performance-based Warrants are a powerful way to align incentives between a startup and a strategically important partner. They allow a startup to reward partners that have brought significant value and successfully accomplished the goals or milestones that were previously agreed upon. Aligning the incentives between a startup and their investor or partner is clearly a good goal, and Warrants are a forcing function for organizations to both track and measure the success of their joint initiatives. Importantly, issuing Warrants carries less risk for startups, because in a situation where your partner fails to deliver, the Warrants cannot be exercised and there’s no equity dilution.

There are many different types of partners and situations that lend themselves well to a performance-based Warrants arrangement. Below, we’ve listed some of the more common ones:

1. Beta Customer (Symbiotic) — In this instance, the customer you are incentivizing is a very early (beta) customer, potentially a marquee name and someone who can help you shape the product and influence other customers in that segment to adopt your solution. The customer benefits from early access to the startup’s technology, while the startup gains implicit or explicit endorsement from the large customer. The “stamp of approval” could be sufficiently valuable to a startup and granting Warrants for joint marketing or other promotional activity could be a good way to align interests.
2. Buyer and Reseller Relationship — In situations like this, a Partner is both a buyer and reseller of the startup’s products. Performance-based Warrants can be a way to reward and incentivize the partner for achieving certain sales targets. When it works well, the startup gets more revenue, and the partner gets to participate in the upside from the startup’s success.
3. Financing Options — When a startup funding round is not big enough to accommodate a strategic investor’s minimum investment amount or percentage ownership requirements, performance- or milestone-based Warrants could be one way to address that gap. For example, if the strategic investor has a $3M minimum investment threshold and only $2M of the round is available, the parties can agree on a mutually agreeable performance-based warrant structure that requires the strategic investor to deliver the value promised by it. Such a financing structure aligns incentives and potentially balances the dilution with the value accrued by the startup.
4. Warrants for Services — it is not uncommon for startups to issue Warrants to Partners or other Stakeholders who provide services to a startup. For example, a startup may grant Warrants to an incubator or accelerator in what is essentially an exchange of services for potential equity. Accelerators could be providing facilities, infrastructure, admin support, cloud credits, talent or other things a startup is lacking, in exchange for Warrants. Similarly, Warrants could be issued to a strategically important partner, who may not have a venture capital arm or the capacity to make a direct equity investment, in exchange for signing an OEM agreement or licensing IP that may prove valuable in the long run.
5. Bank Warrants — it is not uncommon to see Warrants associated with a Venture Debt agreement. When lenders issue debt to startups, they frequently tradeoff the interest rate or other payment terms for Warrants.

There are also scenarios where we’ve seen Warrants being used in less effective, or perhaps onerous, ways, like:

• Pre-money Valuation Adjustment — Although uncommon now, we have seen investors seek Warrants to reduce the pre-money valuation if the management team does not hit revenue targets or operational milestones contained in the investment prospectus. This is effectively the opposite of aligning interests and not a recommended or effective use of Warrants to address valuation gap during a financing round.

Vesting Triggers

Picking the right milestones or events to designate as vesting triggers is a crucial element to ensure success. Carelessly designed, or poorly thought out milestones might incentivize the wrong behavior, which will undoubtedly lead to a poor result. Vesting triggers should be clearly defined, objective, and measurable. Further, they should be regularly tracked and the progress should be monitored by both sides. Below we’ve listed some examples of meaningful vesting triggers:

• A specific number of customer introductions — It is important to identify the set of customers and the introduction criteria that triggers the vesting process. In addition, a timeline by which such introductions should be completed is an important consideration.
• A specific number of POCs (proof of concept) delivered to potential customers — This rachets up the above trigger, forcing a partner to do more than just enable a foot-in-the-door.
• Specific impact on Revenues or Bookings — An effective and meaningful trigger is to set a target for top-line value creation, wherein a partner contributes a certain dollar figure of revenues or bookings.
• Geo-market Expansion — If you’re looking to make inroads globally, you may want to piggyback on your partner’s global presence. Consider targeting a certain amount of bookings generated in a region, like Asia Pacific or Latin America, where you don’t have direct presence.

An example of a vesting structure could be constructed as follows:

• No warrants vest until the Service Provider meets ½ the requirements of the agreed milestone. Such a structure ensures that the Partner needs to meet a certain threshold (Floor) before reaping the earning the warrants.
• 50% of the warrants vest only after ½ the milestones are met
• After this, warrants vest linearly until all milestones are met
• There is a cap at 100% (Ceiling), i.e., no additional warrants are issued after all milestones are met

Note that milestones could be Revenue or Bookings target, number of customer introductions or something meaningful for the management team.

Conclusion

As we’ve shown, across a wide variety of scenarios, Performance-based Warrants can be an effective tool to align interests between a startup and other stakeholders or strategic partners. They not only enable both parties to share in the upside of successful joint initiatives, but also help to formalize these arrangements, incentivizing both sides to monitor and measure their progress. Entrepreneurs would do well to understand the situations in which Warrants can be beneficial and the practical details of how to implement best practices.