You look at your capitalization table and see one number. Your investor looks at it and sees a completely different one. This discrepancy usually comes down to how you count the shares.
There is a massive difference between what exists today and what might exist tomorrow. In the high stakes world of startup equity, the future number is the one that actually matters for determining value.
Defining the Term
#Fully diluted shares refer to the total number of shares of a company that would be outstanding if all possible sources of conversion were exercised. This is not just a count of the stock certificates currently sitting in a file cabinet.
It is a theoretical calculation. It asks a specific question about the cap table.
If everyone who had a right to buy stock did so, how many shares would there be?
To calculate this, you have to aggregate several different asset classes:
- Common stock currently issued
- Preferred stock currently issued
- Stock options that are vested and unvested
- Warrants held by advisors or lenders
- Convertible notes or SAFE notes that will turn into equity
- Shares reserved in the option pool for future employees
This calculation provides the most conservative view of ownership percentage for a founder. It assumes maximum dilution occurs immediately.
Basic Outstanding vs. Fully Diluted
#It is easy to confuse basic outstanding shares with fully diluted shares. Basic outstanding shares represent the actual stock currently held by shareholders. These are the shares that have voting rights today.
If you own 1 million shares and there are 2 million outstanding, you technically have 50% voting power right now.
However, the fully diluted count tells the financial story. If there are another 2 million shares tied up in options and convertible notes, the fully diluted count is 4 million.
In that scenario, your 1 million shares only represent 25% of the economic value of the company. Founders often make the mistake of focusing on the basic count because it feels better. The fully diluted count is the reality check.
When a venture capital firm hands you a term sheet, the price per share is almost always calculated based on the fully diluted capitalization.
Investors want to know what they are buying relative to the entire potential pie. They do not want their percentage ownership to shrink immediately after they invest because of outstanding obligations you already created.
This becomes a major point of negotiation regarding the option pool.
Investors will often require you to create a large option pool for future hires before they invest. They want this included in the fully diluted pre-money valuation. This effectively pushes all the dilution from that pool onto the existing founders rather than the new investors.
Scenario Planning
#Understanding this metric allows you to run better scenarios.
When you are hiring a key executive, are you calculating their percentage grant based on what exists now or the fully diluted number? If you use the wrong denominator, you might promise more equity than you intended.
When you are considering an exit or acquisition, the buyer looks at the fully diluted number to determine the price per share distribution.
Ignoring the fully diluted count does not make the dilution go away. It just ensures you will be surprised by it later.