Recently a question was posed on Quora on “Why do venture debt shops take warrants?”
My answer, which I posted on Quora:
In general, venture debt shops are divided between the bank lenders (SVB, Square 1, etc) and the captive debt funds.
From the venture bank perspective - the companies getting venture debt from a bank typically can’t access a debt facility from a “traditional” commercial bank. This is often because the company is burning cash (i.e. not generating ebitda) and has some level or reliance on additional capital from an institutional equity investor. To compensate for this incremental additional risk, the venture banks typically ask for warrants as a mechanism to get a piece of the upside on the companies which end up being successes. This gravy on top tends to cover the incremental losses associated with lending money to cash burning companies.
Debt funds employ a similar view of the risk-reward trade off but often see the warrant piece as a more defined contributor to a desired internal rate of return against capital deployed. Often, these funds are either seeking a target IRR for their LPs or are themselves borrowing at a lower rate of interest and need to make a spread in order to cover their cost of capital and make money themselves. Thus, valuation of the warrant coverage and potential exit scenarios becomes a significant part of the equation when considering a potential debt facility.