Fully Diluted Shares
/ˈfʊli ˈdaɪˌluːtɪd ʃɛəz/
Learn what fully diluted shares are, including all outstanding shares and potential shares from options and conversions, providing a complete view of company ownership.
Learn what fully diluted shares are, including all outstanding shares and potential shares from options and conversions, providing a complete view of company ownership.
Fully diluted shares refer to the total number of shares that would exist if all convertible securities in a company were exercised into common shares. This calculation includes not only the currently outstanding shares but also all potential shares from stock options, warrants, convertible notes, and any other instruments that could be converted into equity. Understanding fully diluted shares is crucial for founders and investors alike because it provides the most accurate picture of ownership distribution and the potential dilution effect on existing shareholders.
When you're negotiating equity financing, the fully diluted share count becomes the denominator in calculating ownership percentages. For example, if an investor offers €500,000 for 10% of your company, that percentage is based on the fully diluted share count, not just the currently issued shares. This ensures that everyone understands exactly how much of the company is being sold and how existing ownership will be diluted by the investment and any unissued option pool.
For founders, tracking fully diluted shares helps you maintain awareness of how future equity grants to employees or future fundraising rounds will affect your ownership stake. It's a forward-looking metric that captures the potential future state of your company's capital structure, which is why sophisticated investors always focus on this number rather than the basic share count alone.
To calculate fully diluted shares, you start with the basic share count, which includes all issued and outstanding common shares. To this number, you add all shares that could potentially be created through the exercise of convertible instruments. This typically includes employee stock options (both vested and unvested), warrants issued to investors or service providers, convertible debt such as convertible notes, and any other securities that have conversion rights.
The calculation assumes that all "in-the-money" options and warrants are exercised, meaning their exercise price is below the current fair market value of the shares. This is important because if an option's exercise price is higher than the current share value, it would not make economic sense for the holder to exercise it. However, when valuing a company for fundraising purposes, investors typically assume full dilution of all convertible securities regardless of whether they are currently in-the-money.
Most startups maintain a detailed cap table that tracks both basic and fully diluted shares. This document becomes increasingly important as your company grows and brings on more employees with stock options or raises additional rounds of financing. Accurate tracking of fully diluted shares is essential for preventing ownership disputes and ensuring transparent communication with all stakeholders.
Fully diluted shares are critically important in fundraising because they determine the actual ownership percentages being bought and sold. When investors negotiate for a percentage of your company, they're negotiating based on the fully diluted share count. If you only consider basic shares, you might think you're selling 10% of the company when you're actually selling closer to 8% once all options and convertible securities are accounted for.
This distinction matters because it affects the implied valuation of your company. If an investor offers €1 million for what they believe is 10% of your company based on basic shares, but the fully diluted percentage is actually 12.5%, they're getting a much better deal than expected. That's why sophisticated investors always insist on seeing the fully diluted share count before finalising any investment terms.
During due diligence, investors will scrutinise your fully diluted share count to understand how much dilution could occur from existing convertible instruments. They'll also assess whether your option pool is appropriately sized for future hiring needs and whether any unusual terms in your convertible notes could lead to unexpected dilution down the road.
The key difference between basic and fully diluted shares lies in what each measure includes. Basic shares represent only the shares that have actually been issued and are currently outstanding. This includes common shares held by founders, investors, and employees who have exercised their options. It's a snapshot of the current ownership structure without considering any potential future dilution.
Fully diluted shares, by contrast, represent the maximum possible number of shares that could exist if all convertible securities were exercised. This forward-looking view includes shares that don't yet exist but could come into existence through the conversion of options, warrants, or convertible notes. It's the most conservative way to calculate ownership percentages because it assumes all potential dilution will occur.
For founders, understanding this difference is crucial when negotiating with investors. If you only focus on basic shares, you might underestimate how much dilution you'll experience from future option grants or convertible note conversions. Most term sheets specify that percentages are based on the fully diluted share count, so it's essential to calculate this accurately before signing any investment documents.
Fully diluted shares directly impact your company's valuation calculations during fundraising rounds. When investors discuss valuation, they're typically referring to the "post-money valuation," which is calculated as the investment amount divided by the percentage of equity they receive based on the fully diluted share count.
For example, if an investor offers €2 million for 20% of your company based on fully diluted shares, your post-money valuation would be €10 million. If you were mistakenly using basic shares instead and thought they were buying 20% but the fully diluted percentage was actually 25%, your post-money valuation would effectively be only €8 million. This miscalculation could cost you significant value.
Valuation discussions become even more complex when considering option pools. Investors often require that an employee option pool be created before their investment, and this pool is typically included in the fully diluted share count. If you're negotiating a €5 million pre-money valuation but need to create a 15% option pool from that valuation, your effective pre-money valuation is actually lower once the pool is accounted for.
Convertible securities have a significant impact on fully diluted shares because they represent potential future shares that could dilute existing ownership. The most common convertible securities include stock options, warrants, and convertible notes. Each of these instruments contains terms that specify how and when they convert into common shares, which directly affects the fully diluted share count.
Stock options granted to employees typically have vesting schedules and exercise prices. When calculating fully diluted shares, all outstanding options are usually included, regardless of whether they're vested or not. This approach gives investors and founders a complete picture of the maximum potential dilution if all options were to be exercised over time.
Convertible notes, often used in early-stage seed investment rounds, present another layer of complexity. These debt instruments convert into equity at a future financing round, usually at a discount to the price paid by new investors. When valuing a company, investors must consider how many shares those notes will convert into, which depends on both the valuation cap and discount rate specified in the note agreement.
Founders should understand that fully diluted shares represent the most comprehensive view of their company's equity structure. When you're negotiating with investors, always confirm whether percentages are based on basic or fully diluted shares. This clarification can prevent misunderstandings and ensure you're getting fair value for the equity you're selling.
It's also crucial to maintain an accurate and up-to-date cap table that includes all convertible securities. Many early-stage founders make the mistake of only tracking issued shares, then encounter surprises when they realise how much dilution will occur from their option pool or convertible notes. Regular updates to your fully diluted share count will help you make informed decisions about future hiring, fundraising, and equity compensation.
Finally, founders should be aware that different investors may have different approaches to calculating fully diluted shares. Some might exclude certain instruments from their calculations, while others might use different assumptions about which options are "in-the-money." Being transparent about your methodology and understanding your investors' approach will help build trust and facilitate smoother negotiations during your fundraising process.
