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Defenses to Burn Outs ... 'Up the Ladder' Warrants

Joseph W. Bartlett, Special Counsel, McCarter & English, LLP



A private equity fund has one very significant advantage over an angel investor. Angels tend to make a one time investment. They may have pre-emptive rights but the private equity fund has greater resources and can participate in later rounds, some of which may be so-called 'down rounds.' Accordingly, on behalf of its limited partners, the private equity fund may well have superior returns because it has been able to preserve its percentage interest in the most promising deals by participating in the later rounds, rounds which may well be unavailable to the angels because, for example, at that point in time when the round is presented, they do not have the spare cash. A new concept in financial engineering builds into the Angel round a tranche of warrants in favor of the angel investors at significant step ups from the current valuation. Let's say the angels are investing in a pre-money valuation of $3 million and at a post money valuation of $4 million ( $1 million going into the Company). The new wrinkle entails builds one hundred percent warrant coverage for the angels, meaning they can "invest" another $1 million in the Company but they will not have to put up any cash. They will get warrants, the aggregate exercise price of which equals $1 million. The warrants, however, so as not to scare off subsequent venture capitalists, are based on pre-money valuations which are relatively heroic ... 'up-the-ladder warrants.' They are available for (a) the founders; (b) angels and (c) another category of investors which has been discouraged by the fact that dilution eats up their potential profits upon a liquidity event ... meaning universities and teaching hospitals. It is well known in the business that the reason that research-generating institutions have not been able to hit home runs is that they contribute the science in return for equity (if they elect equity in lieu of cash) at the earliest possible stage and, therefore, suffer the same dilutive burdens that the other earlier stage proprietors encounter. Accordingly, the up-the-ladder warrants entail one hundred percent warrant coverage in the example cited but at valuations which are such that everybody will make out ... win/win valuations, if you like. These could be $25 million, $50 million, $75 million, let's say.

To see how the structure works, consider the following example:

Let's say the angels are investing $1,000,000 in 100,000 shares ($10 per share) at a pre-money valuation of $3 million, resulting in a post money valuation of $4 million ( $1 million going into the Company). We suggest angels obtain 100 percent warrant coverage, meaning they can acquire three warrants, totaling calls on another 100,000 shares of the Company's stock; but, so as not to scare off subsequent venture capitalists, the exercise prices of each warrant will be based on pre-money valuations which are relatively heroic ... win/win valuations, if you like. For the sake of argument, the exercise prices could be set at $30, $40 and $50 a share (33,333 shares in each case).

The warrants would be available for (a) the founders; (b) angels and (c) another category of investors which has been discouraged by the fact that dilution eats up their potential profits upon a liquidity event ... i.e., universities and teaching hospitals. [1]

  1. Let's use a hypothetical example to see how this regime could work. Since the angels have invested $1 million at a post-money valuation of $4 million, they, therefore, own 25 percent of the Company ... 100,000 shares out of a total of 400,000 outstanding. The three warrants, as stated, are each a call on 33,333 shares. Subsequent down rounds raise $2,000,000 and dilute the angels' share of the Company's equity from 25 percent to 5 percent ... their 100,000 shares now represent 5 percent of 2,000,000 shares (cost basis still $10 per share) and the down round investors own 1,900,000 shares at a cost (assume only one down round) of $1.05 per share. Finally, assume the Company climbs out of the cellar and is sold for $100 million in cash, or $50 per share.
     
  2. Absent 'up-the-ladder warrants' the proceeds to the angels would be $5 million ... not a bad return (5 x) on their investment but, nonetheless, arguably inconsistent with the fact that the angels took the earliest risk. The 'up-the-ladder warrants' add to the angels' ultimate outcome (and we assume cashless exercise or an SAR technique, and ignore the effect of taxes) as follows: 33,333 warrants are in the money (at $20/share) by $666,666, and 33,333 warrants are in the money (at $10 a share) by $333,333, meaning the angels get another $1,000.000. From the 'down round' investors standpoint, the result is relatively harmless. For an investment of $2 million, if it were not for the 'up-the-ladder warrants,' they would get back $95 million, or 47.5 times their money. If you take out another $1,000,000, which the angels obtained by virtue of their warrants, the slippage is relatively trivial: The result is 47.0 x their investment. Granted, it is not clear why the angels should get any warrants if all the subsequent rounds are 'up' rounds or in the unlikely event there are no subsequent rounds at all. The fix for that problem is simple enough; the warrants are only triggered if the angels are in fact diluted to less than, say, 50 percent of their original holding, and in a down round or rounds.

[1] It is well known in the business that the reason that research-generating institutions have not been able to hit home runs is that they contribute the science in return for equity (if they elect equity in lieu of cash) at the earliest possible stage and, therefore, suffer the same dilutive burdens that the other earlier stage proprietors encounter.