What does fully diluted mean, and why do investors count that way?
Cap tableEquityStock options
Issued and outstanding shares are the shares people own today. Fully diluted shares are those plus every share that could come into existence under something already granted or reserved: options, warrants, convertible preferred counted as if converted, and, in most usages, the shares still sitting unissued in the option pool. Investors quote ownership on the fully diluted basis because it is the only one that does not flatter the holder. A founder with 4 million of 8 million issued shares owns 50 percent today and 40 percent fully diluted if 2 million more are reserved for the plan, and the second number is the one that predicts what they will own after the plan is used.
The two percentages
Take a company with 8 million founder shares issued, 500,000 options granted and 1.5 million unissued in the pool. Issued and outstanding is 8 million. Fully diluted is 10 million. A new hire granted 100,000 options holds 1.25 percent of the outstanding shares and 1 percent fully diluted. The grant is the same 100,000 shares either way; only the sentence describing it changes. Companies are tempted to quote the larger number because it sounds more generous, and that is the reason to quote the smaller one.
Why percentages in offers cause trouble
Promise a hire one percent of the outstanding shares and the promise changes size every time anyone exercises an option. One percent of 8 million is 80,000 shares; after that hire exercises, one percent of the new total is 80,800, and the next hire promised the same one percent gets more shares than the first. Two employees comparing notes will conclude one was shortchanged. Quote a share number in the offer letter and the grant paperwork, explain the fully diluted percentage it represents on the day, and say in plain words that the percentage will fall as the company issues shares to investors and other hires. That sentence prevents the conversation three years later.
Where the definitions vary
Whether the unissued pool is included is a matter of context. A term sheet that prices a round off the fully diluted pre-money almost always includes it, and often enlarges it first. A 409A appraisal may not. A SAFE's definition of company capitalization has its own list, which includes the pool and other SAFEs. When a document uses the phrase, find its definition, because the same words can produce a different price.
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Written by the lawyers who built Arabella. This is legal information, not legal advice for your situation, and reading it does not make us your lawyers. For a real dispute or a high-stakes decision, talk to a licensed attorney. More questions.