Setting the strike price for a warrant

If you decided to issue warrants as opposed to the more tax efficient QESOs (find out which to use here), one of the most important aspects is what strike price you should set. The strike price is the price per share you pay when you use the warrants to buy shares, and it also effects the price you pay for the warrant at the beginning of the warrant program; this is often called the warrant premium.

If at the end of the warrant program the value of the share is higher than the strike price, then the warrant is said to be in the money and it makes sense to use the warrant to buy shares. So the lower the strike price, the higher the likelihood that the warrant will be in the money. And a lower strike price also requires you to pay less for the shares. If you have 10,000 warrants at a strike price of 20 kr, you have to pay 200,000 for the shares (20 * 10,000 = 200,000), but if the strike price is 50 kr, you have to pay 500,000 kr (50 * 10,000 = 500,000).

This makes it easy, one may think: Aim for the lowest possible strike price. However, there is a catch. The lower the strike price, the higher the warrant premium. The warrant premium is calculated using the Black-Scholes formula, and besides the length of the warrant program and the volatility, the strike price is perhaps the most important parameter determining the price. The Black-Scholes formula is not at all intuitive, but the general idea is that the lower the strike price, the higher the warrant premium, and conversely, a high strike price gives a lower warrant premium. If you want to play around with it, it is built into the StartupTools platform and also available as a google spreadsheet.

Ideally, you would want a strike price which is as low as possible. The problem is that the lower it gets, the more expensive the warrant becomes. At the extreme – if you set the strike price at zero (or rather the quota value, which is almost but not quite zero), then the price of the warrant is equal to the current price of the stock, which means that you might as well buy the stock right away.

Here is an example of what the warrant premium becomes at different strike prices. We assume that the company has 2.5 million shares to start with, and that the current valuation is 50 million kr, that is 20 kr per share. We also assume that the volatility is 30% and the risk free interest rate is -0.0151% (the actual rate when this article is written). We also assume that we issue 25,000 warrants, corresponding to 1 % of the shares.

Strike Price 20Strike Price 30Strike Price 40
Price per share when
warrants are issued
(company valuation = 50 million kr)
20 kr20 kr20 kr
Strike price per share20 kr30 kr40 kr
Company valuation at strike50 million kr75 million kr100 million kr
Price per warrant4.7 kr2.1 kr1.0 kr
Number of warrants25,00025,00025,000
To pay when warrants are issued117,796 53,256 kr25,259 kr
To pay when shares are issued500,000 kr1,000,000 kr1,500,000 kr

In this scenario, the company needs to be worth more than 50 million kr for the warrants to be worth anything. If the company eventually sold at 40 kr per share, corresponding to a company value of 100 million kr, then the profit is 500,000 kr if the strike price was 20 kr, 250,000 if the strike price was 30 kr and nothing if the strike price was 40 kr or above. Also note that this depends on the price per share. If we assume that the company has issued 1 million more shares to raise money, then a company valuation of 100 million kr corresponds to a share price of 28.6 kr (100 million kr / 3.5 million shares = 28.6 kr per share). With that share issue, the company would have to reach a valuation of 140 million kr to reach 40 kr per share.

A common problem is that you start by deciding the number of warrants to offer, then ask the employee (we assume it is an employee who will be the recipient) how much they are willing to spend, and then set the strike price to match that. The problem here is that the employee may opt for a low price today, which makes the strike price so high that the warrants never becomes in the money. Offerring warrants that eventually turn out to be worthless may even be worse for motivation than not offerring warrants at all, since you have made the employee pay something, but then in end not getting anything in return.

An alternative approach you may want to try instead is this:

  1. Set the strike price at the current value. This makes the employee be part of all the value creation they participate in, and unless the company completely fails, the chances are high that the warrants will be in the money.
  2. Ask the employee how much they are willing to spend. Instead of adjusting the strike price, lower the number of warrants to match what they want to pay.
  3. Is the number of warrants now too low for what the employee wants (and the company is willing to offer)? Instead of raising the strike price, considering lending the money to the employee. If the employee is not a shareholder already, then it is permissible for the company to lend the employee the money for the warrant. As an example: if the warrants cost 48,000, then instead of paying the whole amount up front, you could let the employee pay in monthly instalments. If it is a four year (48 month) program, then in effect the employee gets around 1000 kr less in salary each month. While in total this amounts to the same thing, it may be less taxing on the employee’s finances than to pay the whole amount up front. If you do this, just make sure you charge interest on the loan – otherwise it may be considered a taxable benefit.

This of course only works if the employee is not already a shareholder, and they are willing to pay in instalments. Sometimes this will not do. A situation we have come across several times is that an early employee – not quite a founder, but almost – is promised a significant part of the company at no cost. But then financing happens faster than expected, and the company’s value is now too high to sell shares. Now what? What you could do here is to issue warrants at a fairly low price, then pay out a one time bonus to cover the cost. While this works in theory, it is very expensive. Using the above example, where an employee should get 100,000 warrants, corresponding to 4% of the company and with a strike price of 20 kr, the total price for the warrants would be 471,184 kr. If we assume the tax rate to be 50%, we would need to pay a gross salary of 942,368 kr and on top of that pay payroll taxes of 31.42%. Thus the total cost to the company would be 1,238,460 kr.

The moral of this is course that you want to bring in board your co-founders as early as possible, if not possible, consider giving them QESOs instead.


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