Fully-Diluted Capitalization

When fundraising, the main topic of negotiation is often the pre-money valuation used to calculate the price of stock issued to investors. Pre-money valuation refers to the valuation of the startup prior to the fundraising. The pre-money valuation matters because it determines the percentage of the corporation an investor will receive in exchange for their investment.

Startup investors typically calculate their percentage ownership based on the fully-diluted capitalization of the corporation. Capitalization, in this context, refers to the capital structure of a corporation - i.e. the structure of the equity and debt of a corporation. The term diluted refers to the fact that the ownership percentage represented by each share of stock is diluted each time new shares are issued. The term fully-diluted means that the capitalization is calculated assuming that all plans and obligations (whether outstanding or potential) to issue shares have been fulfilled.

Thus, a startup's fully-diluted capitalization commonly assumes:

• all preferred stock has been converted to common stock;
• outstanding options, warrants, and other securities with a right to acquire shares have been exercised; and
• any shares reserved for issuance under a stock plan have been issued.

There is no single definition of fully-diluted capitalization. For example, un-issued shares reserved for issuance under a stock plan can be excluded from a fully-diluted capitalization. This is commonly done when the fully-diluted capitalization is being calculated in connection with the acquisition of a startup, since startups typically do not issue equity following an acquisition. By contrast, these shares are almost always included in a fully-diluted capitalization in the context of equity compensation. Another possible difference is with securities that convert into stock in connection with a preferred stock financing, such as convertible notes and safes. Some definitions of fully-diluted capitalization assume the conversion of these securities, while others do not.

The securities of a startup can almost always be ultimately converted into common stock, so it is common to see the fully-diluted capitalization expressed as a single number of shares.

Example

A startup with the following capital structure can be said to have a fully-diluted capitalization of 8,500,000 shares, if un-issued shares reserved for issuance under a stock plan are excluded:

• 8,000,000 shares issued and outstanding;¹
• 1,000,000 shares reserved for issuance under a stock plan² for employees and consultants, of which:
  • 500,000 shares are subject to outstanding options and
  • 500,000 shares remain available for issuance; and
• 1,000,000 shares informally set aside for accelerators or additional co-founders

If un-issued shares reserved for issuance under a stock plan are included, then the startup could be said to have a fully-diluted capitalization of 9,000,000.