Startup warrants, what they are, how they work and what they dilute

A startup warrant is a right, but not an obligation, to buy shares in a company at a fixed price within a fixed period. The company grants the warrant as part of a larger deal, and the holder decides later whether to pay the strike price and take the shares.

Warrants sit alongside other financing instruments in Australian startup deals, but they are less understood than convertible notes or SAFEs because their cost is not visible at the moment they are granted. This article explains what a warrant actually gives the holder, the key terms that decide its value, how exercising one dilutes existing shareholders, and the Australian rules that apply when a company issues warrants. It covers:

• Definition: what a warrant is, and how it differs from employee options, convertible notes and SAFEs
• Economics: strike price, coverage, term, vesting and anti-dilution
• Dilution: a worked example on an Australian cap table
• Compliance: the Corporations Act and tax treatment that apply
• Getting help: where a capital raising lawyer adds value

What a warrant actually gives the holder

A warrant is a contractual right to acquire shares from the company itself. The holder can exercise it by paying the strike price and receiving the agreed number of shares, or simply let it lapse. The company cannot force the holder to exercise, and nothing happens automatically at the end of the term if the holder does nothing.

No shares are issued and no funds are raised unless and until the warrant is exercised. This is what separates a warrant from a convertible note or a SAFE. A convertible note involves the advance of capital now, and a SAFE is an agreement for future equity; both convert automatically on a triggering event, typically the next priced round. A warrant converts nothing. The holder chooses, at a time of their choosing within the term, whether the deal is worth completing.

Because of this optionality, a warrant behaves more like an equity option than a deferred equity instrument. Its commercial impact depends entirely on whether it is exercised, when that happens and at what price.

One Australian framing point matters here. Under s 92 of the Corporations Act 2001 (Cth), an option to acquire a share by way of issue is not a derivative. It is a security in its own right, which has real consequences for the fundraising rules discussed later in this article.

Warrants versus options: same shape, different parties

Mechanically, a warrant and an option are near-identical. Both are rights to acquire shares at a set price, and both can be drafted with vesting, expiry and adjustment provisions. The practical difference in startup deals is who receives them and why.

Employee options are granted to employees, directors and contractors under a formal employee share scheme or option plan, usually at the market value of the shares at grant, and are taxed under Division 83A of the Income Tax Assessment Act 1997 (Cth) with concessions designed for start-ups. The plan defines who can participate, and most plans only permit issues to people providing services to the company.

Warrants fill the gap for everyone else. Lenders, investors, strategic partners and advisers are typically not eligible under an option plan, so a warrant is the vehicle used to give them upside in connection with a deal they are doing with the company rather than work they are doing for it. As market commentary on warrant practice notes, the warrant acts as a sweetener that aligns the third party's incentives with the company's growth.

The strike price and warrant coverage

Two terms drive the economics of a warrant:

• Strike price: the price per share the holder pays on exercise. It is usually set by reference to the company's valuation at the time the warrant is granted, or at a discount or premium to the price of a future equity round. Sometimes it is set at a nominal figure, such as $0.01 a share, which makes the warrant effectively a pre-funded grant of shares. Because exercise may happen years after grant, the strike price decides whether the warrant delivers genuine upside to the holder or simply adds dilution to the company.
• Coverage: how much equity exposure is attached to the warrant. In a venture debt deal it is expressed as a percentage of the loan amount, not a percentage of the company. Market data from venture lenders suggests coverage of 2% to 10% of the loan is common, which typically transfers roughly 0.5% to 2% of the company to the lender on a fully diluted basis. In advisory or strategic deals, coverage is more often expressed as a percentage of the company's share capital or a fixed number of shares.

Because coverage sets the size of the future share issue, it usually drives dilution more directly than the strike price. A small difference in coverage can mean tens of thousands of additional shares over the lender's head by the time the warrant is exercised.

Term, vesting and how exercise works

Warrants commonly run for terms of 2 to 10 years, and sometimes up to 12, with the value of the warrant increasing with the length of the term because there is more time for the company to grow into a liquidity event. The exercise period may also be structured so that the warrant can only be exercised after certain events, such as a future funding round or a sale.

Warrants may include vesting provisions that determine when the holder becomes entitled to exercise. Vesting can be:

• Immediate: the warrant is exercisable from issue
• Time-based: exercisability accrues over a defined period, typically alongside the delivery of services or the life of a loan
• Milestone-based: exercisability is linked to performance or transaction outcomes
• Hybrid: a combination of time-based and milestone-based conditions

Exercise itself can be paid in cash or structured as a cashless exercise. In a cashless exercise the holder receives a reduced number of shares, with the reduction equal in value to the exercise price that would otherwise be paid, so no money changes hands. In private companies cashless exercise is often limited to a sale or public offering, because those events create the liquidity that makes the mechanics workable.

Anti-dilution protection

Some warrants include anti-dilution provisions that protect the holder if the company later issues shares at a lower price. If a down round occurs, the warrant's strike price is adjusted downwards, the number of shares issuable on exercise is increased, or both. The adjustment may be a full ratchet, where the strike price drops to the new round price, or a weighted average formula, which blends the old and new prices across the existing share count.

Anti-dilution provisions are not universal. They are more common in financing-linked warrants, where the holder is providing capital and wants downside protection, than in advisory arrangements, where the warrant is compensation for services rather than an investment. Where they are included, they can materially change the economics of the warrant over time and should be reviewed alongside the company's fundraising plans.

A worked example: what exercising a warrant does to the cap table

FreshPick, an Australian software company, has 10 million shares on issue after a $10 million post-money Series A at $1.00 a share. It borrows $1 million from a venture debt lender to fund expansion. The lender asks for 8% warrant coverage, meaning a warrant over $80,000 worth of shares at the Series A price, or 80,000 shares, about 0.8% of the company.

The warrant has a 5-year term and a strike price of $1.00. Eighteen months later FreshPick raises a Series B at $4.00 a share. The lender exercises: it pays $80,000 and receives shares worth $320,000, a fourfold gain, while the company issues 80,000 new shares. Every existing shareholder's percentage falls slightly, but the Series B investors priced the company knowing the warrant existed, because outstanding warrants count on a fully diluted basis. The dilution was never a surprise; it was modelled into the round.

Change the coverage to 20% and the same $1 million loan puts 200,000 shares over the lender's head, roughly 2% of the company, and the lender's gain at the Series B price becomes $800,000. The headline deal looked identical, but the dilution outcome was two and a half times larger. This is why coverage, not the strike price, is usually the number to negotiate hardest.

Common misconceptions about warrants

Four misconceptions about warrants recur in startup deals:

• "Warrants don't dilute anyone until they are exercised": Mechanically true, but misleading. Outstanding warrants count on a fully diluted basis, so new investors value the company and price their rounds as if the warrants will be exercised. The dilution is deferred, not avoided, and it lands on the cap table at exactly the moment the company is raising again.
• "Warrant coverage is the percentage of the company the lender gets": It is not. Coverage is a percentage of the loan or investment amount. The actual equity transferred is much smaller, typically well under 2% of the company in a venture debt deal, which is why warrants are often described as a cheap way to pay for debt.
• "Granting a warrant is just a private contract, so there is nothing to comply with": Offering warrants engages the fundraising rules in Chapter 6D of the Corporations Act 2001 (Cth). Section 702 treats an offer to grant an option as an offer of the security constituted by the option, and s 706 requires disclosure to investors unless an exemption in s 708 applies, such as the small-scale offering exemption for personal offers to no more than 20 investors raising no more than $2 million in 12 months. Section 727 prohibits offering securities that need disclosure without a disclosure document lodged with ASIC.
• "A warrant is the same as an employee option, so it can be issued through the ESOP": The mechanics are similar, but the parties and the tax treatment differ. Employee options are taxed under Division 83A of the Income Tax Assessment Act 1997 (Cth) with special concessions, while a warrant granted to a lender or investor sits outside that regime. Issuing a third-party warrant through an option plan also risks breaching the plan's eligibility limits.

The Australian rules that apply when warrants are granted

Three Australian requirements deserve attention before a company issues warrants.

First, the register of option holders. A company that grants options over unissued shares must keep a register of option holders and copies of the option documents under ss 168 and 170 of the Corporations Act 2001 (Cth), and must update it whenever options are exercised or expire.

Second, pre-emption on the issue of shares. For a proprietary company, s 254D of the Corporations Act (a replaceable rule) requires the directors to offer new shares of a class to existing holders proportionally before issuing them to anyone else, unless the company's constitution displaces the rule. Issuing shares on warrant exercise can trigger this requirement, so the constitution should be checked before the warrant is drafted.

Third, tax. If warrants are issued to employees or contractors as part of an employee share scheme, Division 83A of the Income Tax Assessment Act 1997 (Cth) applies. The discount on the interest is generally included in the employee's assessable income at acquisition under s 83A-25, subject to the start-up concession in s 83A-33 and the deferred taxing point rules for rights to acquire shares in s 83A-120. The ATO's employee share scheme guidance explains the eligibility conditions, which changed in 2015, and the safe harbour valuation methods available to unlisted start-ups.

Where a capital raising lawyer adds value

Most of the value a capital raising lawyer provides in a warrant deal happens before the warrant is signed. A lawyer will negotiate the strike price and coverage against the company's valuation and future round plans, work out whether the grant needs disclosure under Chapter 6D and which exemption applies, and check the constitution for pre-emption and class rights issues.

The lawyer will also structure employee and contractor warrants to fit the employee share scheme regime, including the start-up concessions and safe harbour valuations, and will draft the warrant deed itself, covering cashless exercise, anti-dilution, change of control and what happens to the warrant in a sale or IPO. Finally, the lawyer models the dilution impact across future rounds, so the warrant's cost is visible on a fully diluted basis before the deal is done rather than discovered at the Series B.

The fully diluted question

Before signing any warrant, ask what the cap table looks like fully diluted, if every outstanding warrant and option is exercised tomorrow. That single question exposes the real cost of the deal, because it forces a comparison between the headline terms and the eventual ownership outcome.

The misstep that costs founders most in warrant deals is not agreeing to a strike price that is too low. It is granting warrants without ever modelling their fully diluted impact across the next two rounds, and then discovering at the next raise that the lender, adviser or partner holds more of the company than the headline terms suggested. A capital raising lawyer runs those scenarios, checks the disclosure position and keeps the register current, so the warrant's cost is known when it is granted, not discovered later.