Valuation is a key factor in the startup fundraising ecosystem. Valuation determines the price investors pay for their shares in a priced round. This in turn determines how much of their company startup founders have to sell to get the investment they need. Higher valuations mean investors have to pay more to purchase the target percentage ownership they want in the startup.
This raises a question though—how is the target percentage ownership that investors want calculated?
Investors, in general, expect their target percentage ownership to be calculated in reference to the “fully-diluted capitalization” of the startup. The term fully-diluted capitalization can mean different things depending on the setting. However, in this setting, it’s typically rooted in the assumption that all preferred stock has converted to common stock, all outstanding options and warrants have been exercised, and all shares allocated to the option pool have been issued. In other words, it assumes that everything that currently is or could become common shares is counted.
This is in contrast to calculating ownership percentage in reference to issued and outstanding shares. This calculation looks only at the shares that have actually been issued.
Let’s look at some numbers to help illustrate these concepts.
AutoBot Inc. authorized 10 million shares of common stock when it incorporated. It promptly issued 7.5 million shares to the founders. It also allocated 2 million shares to the option pool. The remaining 500,000 authorized shares it set aside in case of bringing on an additional co-founder. Since that time, AutoBot has made a number of option grants to employees and consultants resulting in 250,000 shares from the option pool being subject to options. It has not brought on an additional co-founder and thus the remaining 500,000 authorized shares have not changed.
At this point, the fully-diluted capitalization of AutoBot would be 9,500,000, at least assuming that the shares allocated to the option pool but not yet subject to outstanding options are counted. If those shares are not counted, then the fully-diluted capitalization would instead be 8,250,000. This is why definitions matter. Startup founders should always review investment terms carefully, particularly related to valuation, and get help from a startup lawyer.
To drive home the difference between calculating percentage ownership based on fully-diluted capitalization and issuing and outstanding shares, let’s looks at the issued and outstanding shares in the above example. Since issued and outstanding shares only counts the number of shares that have actually been issued, AutoBot’s issued and outstanding shares would be 7.5 million—the number of shares issued to the founder’s when the company incorporated. Note that the 250,000 shares subject to options are not counted in this calculation. The reason for this is that options only give the holder an option to purchase the shares in the future; until the option is exercised, the shares remain unissued.