Fully Diluted Capitalization — VC Vocabulary
It’s time for back to school. We have come across lots of confusion surrounding the definition of fully-diluted capitalization, specifically, what it consists of and what is excluded. Often times companies and investors have trouble figuring out what the ownership percentages in a company should be and what causes of dilution should be taken out of captable calculations in connection to venture capital financing. Below we will give you a general overview which should provide some clarity.
Fully-diluted capitalization typically means issued stock (common and preferred stock, as if converted to common stock), issued options (or warrants, which are similar to options) and (usually) options reserved in the stock option pool. That is, it assumes that the entire option pool has been granted, and that all of those options have been exercised.
A company’s fully-diluted capitalization typically includes:
- outstanding common stock;
- outstanding preferred stock (calculated on an as converted to common stock basis)
- outstanding options;
- outstanding warrants (on an as exercised and as converted to common basis);
- restricted shares; and
- options reserved for future grant (aka, the “option pool”);
Options and warrants
Investors generally require that a company’s fully-diluted capitalization include all outstanding options and warrants, and the reason behind is that even though the owner of those options and warrants may not get a chance to use them, companies commonly grant a similar number of options or warrants to the parties who would take their place.
Example: SeedVC is going to invest $2 million into YCCo based on an $8 million pre-money valuation. The term sheet states that the fully diluted capitalization should include all outstanding stock plus granted options and warrants. YCCo’s fully diluted capitalization is as follows:
Here, the price per share that SeedVC would pay for its stock would be: $8 million (pre-money valuation) / 8 million shares (fully diluted capitalization) = $1. Therefore, SeedVC’s $2 million investment would buy it 2 million shares.
Shares reserved in an employee option plan
Similarly, investors like to see any shares that have been set aside in an employee option plan being included in the fully-diluted capitalization. This also is based on the assumption that the company is likely to grant options for all shares of that kind in the future and the holders of such options will convert their options for stock, which, again, would impact the ownership stakes. Basically, this provides clarity to the investor who wants to know how exactly its ownership would ultimately be impacted by the exercise of the options, warrants, and grants.
Example: SeedVC is going to invest $2 million into YCCo based on an $8 million pre-money valuation. The investment term sheet dictates that the fully diluted capitalization include all outstanding stock, all granted options and warrants and any shares reserved but unissued under an employee incentive plan. YCCo’s fully diluted capitalization is as follows:
The price per share that SeedVC would pay for its stock would be: $8 million (pre-money valuation) / 9 million shares (fully diluted capitalization) = $0.8889. Therefore, SeedVC’s $2 million investment would buy it 2.25 million shares.
Employee option pool
Most of the times investors expect that a company should increase the number of shares that has been set aside in an employee option plan. What is more, they usually require that the fully diluted capitalization of the company include all such shares set aside. The reasoning behind it is on the presumption that the company will have to grant service providers a greater number of options than it has available in the company’s employee option pool, and the holders of such options would exercise those options for stock. This is often resulted by new hires that are made with the money invested by an investor.
Example: SeedVC is going to invest $2 million into YCCo based on an $8 million pre-money valuation. The term sheet dictates that the fully diluted capitalization include all outstanding stock, granted options and warrants, any shares reserved under an Employee Incentive Plan and an increase in the shares reserved under an employee incentive plan. YCCo’s fully diluted capitalization is as follows:
The price per share that SeedVC would pay for its stock would be: $8 million (pre-money valuation) / 10 million shares (fully diluted capitalization) = $0.80. Therefore, SeedVC’s $2 million investment would grant it 2.5 million shares.
Convertible securities
Occasionally it is common practice for investors to require that a company’s fully-diluted capitalization include all shares of stock that are being issued in the financing on account of convertible notes or SAFEs that would be converting in connection with a financing. The reason for such addition is that:
· the company already received the money for such convertible notes or SAFEs and
· because there is no new money flow, any shares issued in consideration for the conversion of such securities should be counted as if they were outstanding prior to the new investment (ie, rather than treating such shares as if issued for new cash able to be leveraged by the company).
Example: SeedVC is going to invest $2 million into YCCo based on an $8 million pre-money valuation. The investment term sheet dictates that the fully diluted capitalization should include all outstanding stock, all granted options and warrants, any shares reserved under an employee option plan, an increase in the shares reserved under an employee option plan and all shares issued in consideration for Convertible Notes and SAFEs. YCCo’s fully diluted capitalization is as follows:
The price per share that SeedVC would pay for its stock would be: $8 million (pre-money valuation) / 11,000,000 shares (fully diluted capitalization) = $0.7273. Therefore, SeedVC’s $2 million investment here would buy it 2.75 million shares.
All things considered, there is no exclusive definition of fully-diluted capitalization. For instance, un-issued shares reserved for issuance under a stock plan may or may not be included in a fully-diluted capitalization. In the context of venture financing, however, fully-diluted capitalization commonly includes all shares of stock allocated to the corporation’s option pool, despite of whether such shares have been granted as equity awards or remain reserved and unissued.
Conclusion
Ultimately, the goal of defining the company’s fully-diluted capitalization is that it allows the parties to have a clear overview of the company’s ownership percentages in certain events. The investor will generally want to include as much in the capitalization as possible as this will result in higher investor ownership of the company. Defining the fully-diluted capitalization with as much information as possible is a necessary precaution that will ensure that all parties are on the same page.
