How to Use Warrants to Pay Investment Banking Fees

Qualified investment banks usually charge monthly retainers and a cash success fee when they help business owners raise capital, growth equity, or other outside financing. In this article, we explore how to incorporate warrants into the overall compensation business owners pay to investment bankers when raising equity capital. We also discuss some of the pros and cons of using warrants versus straight cash compensation.

As we discussed in “How to Structure the Investment Banking Engagement Letter”, typically investment bankers charge a non-refundable deposit or retainer plus a success fee based on closing a capital raise. A portion of that success fee can be structured as equity compensation which allows the investment bank to realize additional compensation should there be a subsequent liquidity event such as a sale or IPO of the company. Usually, equity compensation paid in exchange for investment banking services is in the form of warrants. Warrants give the investment bank the right, but not the obligation, to purchase stock of the company sometime in the future. A good overview and description of warrants can be found here.

Using the same example from “Business Valuation: An Introduction to Pre/Post Money Valuation”, suppose you and a partner start a company. You initially issue 1,000,000 shares of stock and divide them equally between you and your partner. After some success, you decide you need additional capital to continue to grow your business and you hire an advisor to help raise funds. They charge a success fee of 10%, with 5% of the fee in the form of cash compensation and 5% in the form of warrants.

So when the advisor finds an investor willing to invest $5 million at a post-money valuation of $15 million (giving an implied pre-money valuation of $10 million and the investor 500,000 shares) the intermediary will receive a success fee of $250,000 in cash plus 25,000 warrants.

Now suppose it is a few years later, the capital has helped the business grow and through some great strategic decisions and exceptional management, your company is in an excellent position. You sell your company for $45 million. The intermediary will exercise the warrants which will give them 25,000 shares of the company, representing a 1.64% (25,000/1,525,000) ownership position in the company. With the sale and assuming the warrants are “penny” warrants (i.e. the strike price is $0.01), the intermediary will receive approximately $740,000. Notice that as the company’s value tripled from $15 million to $45 million since you raised the capital, the intermediary recognized approximately triple the fee amount ($250,000 to $740,000). Obviously, it is not an apples to apples fee comparison given the time value of money and the uncertainty of the future sale, but in this case, the advisor was rewarded heavily for taking a risk alongside you and rolling a portion of the success fee into equity instead of taking up front cash.

As a business owner, there are substantial benefits to using warrants to compensate an intermediary. First, intermediary fees can be significant in terms of the percentage of capital raised, particularly in smaller capital raises. Using warrants can decrease the current cash outlay, thereby increasing the amount of capital you have to continue to grow your business. Additionally, it will align your interest of creating long-term value with the intermediary’s compensation. If an intermediary owns a portion of your company after the capital raise is complete, they are more likely to provide ongoing introductions as well as occasional free advice and strategic guidance. But if they have received 100% of their consideration in cash, they are more likely to be devoting 100% of their resources to their next assignment.

There are, of course, some considerations when using warrants. Most significantly, it would be partially in the intermediary’s interest to have a lower valuation of the company at the time of the investment so they will receive more warrants. This risk can be mitigated by using an experienced, qualified, trusted advisor. Additionally, offering warrants can dilute your ownership position, but as we have said before, it is better to have a smaller percentage of a big pie than a large percentage of a small pie.

Additional capital can sometimes help you take your business to the next level. Although getting the most qualified investment banker you can may not be cheap and you may give up a small amount of upside by using warrants, the better bankers can more than make up for higher compensation by providing superior service and giving you the best chance of raising the capital you need.

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