Fully-Diluted Capitalization – What it Means and How it’s Used
You hear a lot of jargon in the world of technology startups and venture capital, and “fully-diluted capitalization” or “on a fully-diluted basis” are some of those terms that get thrown around a lot, but often times are not fully understood. This article will discuss what fully-diluted capitalization means, how it’s calculated, and the common ways it is used.
What is Fully-Diluted Capitalization and how do I Calculate it?
The easiest way to think about fully-diluted capitalization is to think of shares of your company’s stock that are already spoken for. In addition to issuing shares of common stock to the founders, it is common for a startup’s board of directors to reserve shares of common stock for issuance to employees and other service providers under its equity incentive plan. If your startup has already done a round of equity financing, then it also has preferred stock outstanding. Additionally, a startup may issue warrants that are exercisable for shares of common stock or preferred stock (usually as additional kickers for equity investments). When determining a company’s fully-diluted capitalization, all shares of common stock outstanding; all shares of preferred stock outstanding (calculated on an as-converted to common stock basis); and any other securities that are exercisable or convertible into shares of stock must be aggregated (and if such other securities are exercisable or convertible into shares of preferred stock, they must be calculated on an as-converted to common stock basis).
Here’s an example of a typical startup that has issued some common stock to its founders, raised a Series Seed financing (with the Series Seed Preferred Stock initially converting into Common Stock at a 1:1 conversion ratio), offered 20% warrant coverage to entice Series Seed investors, and reserved shares of common stock for issuance under its equity incentive plan equal to about 18% of its pre Series Seed fully-diluted capitalization:
COMMON STOCK: 8,000,000 shares outstanding
SERIES SEED PREFERRED STOCK: 850,000 shares outstanding (on an as-converted basis)
SERIES SEED PREFERRED STOCK WARRANTS: Warrants to purchase 170,000 shares of Series Seed Preferred Stock outstanding
EQUITY INCENTIVE PLAN: 1,500,000 shares reserved for issuance under the plan
Fully-Diluted Capitalization: 10,520,000
Notice how in determining the fully-diluted capitalization we assumed full exercise of all of the Series Seed Warrants and conversion into Common Stock, as well as full issuance and exercise of all options under the equity incentive plan. If the example company had later done a dilutive transaction that triggered an adjustment to the conversion price of the Series Seed Preferred Stock (let’s assume triggering a 1:1.1 adjusted conversion ratio), then the number for the Series Seed Preferred Stock would be adjusted from 850,000 shares to 935,000 shares (on an as-converted basis). The Series Seed Warrants would then also be adjusted from 170,000 to 187,000 because they would be considered exercised into 170,000 shares of Series Seed Preferred Stock and then converted into Common Stock at a 1:1.1 conversion ratio, increasing the fully-diluted capitalization number from 10,520,000 to 10,622,000.
How and When is Fully-Diluted Capitalization Typically Used?
Fully-diluted capitalization is particularly helpful when discussing with any potential investor or other equity holder (such as a highly skilled service provider negotiating for a stock option grant), how much of the company they will own after acquiring the equity (or the right to acquire equity – such as a stock option). Likewise, investors want to know what percentage of the company their investment will buy, and a fully-diluted capitalization gives them a snapshot of the minimum percentage of the company they will own, assuming full conversion and exercise of all convertible or exercisable securities (and thus their relative rights upon a liquidation) on the date they acquire their shares. Fully-diluted capitalization is also used when determining the share price of an equity investment. Typically the price per share in an equity investment is determined by [pre-money valuation] / [fully-diluted capitalization immediately prior to investment].