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Fully diluted shares is a measure of how many outstanding shares your company has in issue following the conversion of any options into shares. It is a critical figure in startup financing because it is a way for investors to measure the value of their investment in the future. This article will consider fully diluted shares in more detail.
What are Conversion Rights?
Fully diluted shares are relevant when a company has an agreement with investors that gives them conversion rights. Conversion rights typically arise from any convertible loan notes or preference shares financing. These financing arrangements give investors the right to convert some of the loan notes or preference shares to ordinary shares in the company.
Conversion rights exist to entice investors. Absent conversion rights, a debt investor cannot fully participate in a startup’s profits if it later becomes successful. However, if the startup does not grow as expected, the investor can refuse to exercise their conversion rights. This preserves their initial investment and gives them downside protection.
Conversion Rights and Diluted Shares
The effect of investors exercising their conversion rights is that it dilutes the existing share capital. The easiest way to appreciate the concept of fully diluted shares is to consider an example.
YouCo Ltd: Case Study
Suppose YouCo Ltd currently has 100,000 £1 shares issued to its founders. It has no other shares, nor does it have any outstanding conversion arrangements. However, it has approached a group of investors that are prepared to loan YouCo £250,000 in the form of convertible loan notes.
The terms of the convertible loan notes contain the following:
- Investors have the right to convert 25% of their loan notes to ordinary shares in advance of YouCo’s next equity financing round. Each loan note is worth £1, meaning there are 250,000 loan notes.
- The conversion right entitles the investors to purchase shares at a 25% discount relative to future equity investors.
- YouCo agrees to limit its valuation to no more than £1m when calculating the conversion price for the convertible note holders. This means that if YouCo is valued at more than £1m, the investors benefit from the lower valuation.
Additionally, YouCo has agreed to offer all its current employees options to purchase shares before its next equity financing. Under an employee share scheme (ESS), it specifies that:
- employees are not entitled to more than 10,000 shares; and
- employees that exercise the purchase option pay £0.10 per share.
There are 10 eligible employees.
Why is it Necessary to Calculate Fully Diluted Shares?
When YouCo seeks further equity financing in the future, future and existing investors will want to know what YouCo’s fully diluted share capital will be. This is because YouCo’s existing ordinary share capital does not reflect the fact that others — loan noteholders and current employees — have the right to obtain ordinary shares in the future. However, if and when the noteholders and current employees exercise their rights, YouCo’s existing share capital will be diluted.
To calculate this, YouCo’s management and investors must make two assumptions:
- How much will YouCo raise in the next round of equity financing?
- How much will YouCo price each newly issued share?
The answers to these assumptions depend on the valuations that YouCo and the potential equity investors agree to. This will depend on how much capital the potential investors wish to invest.
Calculating Fully Diluted Shares
For simplification purposes, assume YouCo will issue new shares for £1 each, based on a £3m company valuation. On this basis:
- If all loan noteholders exercise their conversion rights, in total they can all convert 62,500 out of 250,000 notes into ordinary shares.
- The terms of the convertible loan notes mean the conversion price is 25% less than equity financing, which is £1 per share. As such, each ordinary share will cost noteholders £0.75 to convert, or £46,875.
- Additionally, the ESS terms mean that current employees can each purchase up to 10,000 shares at £0.10 each.
Based on the above, YouCo’s fully diluted share capital ahead of the next equity financing is as follows.
| Existing ordinary shareholders | 100,000 shares |
| Noteholders exercising options | 62,500 shares |
| Employees exercising options | 100,000 shares |
| Total fully diluted share capital | 262,500 shares |
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Key Takeaways
Fully diluted share calculations play a vital role in startup financing. These calculations determine the total number of shares a company would have if all convertible loan notes and employee share options were converted into ordinary shares. By considering the impact of conversion rights, fully diluted share calculations provide a comprehensive view of a company’s capital structure. They help investors and founders assess the potential dilution of existing shareholders and understand the ownership percentages in various scenarios. In practice, calculating fully diluted shares can be quite complex due to terms of existing conversion rights and valuation considerations.
If you need help understanding share dilution, our experienced startup lawyers can assist as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us today on 0808 196 8584 or visit our membership page.
Frequently Asked Questions
Fully diluted share calculations are important in startup financing because they provide a comprehensive understanding of a company’s capital structure. By considering the potential conversion of convertible securities, these calculations help investors and founders assess the dilution of existing shareholders and the impact on ownership percentages.
Conversion rights granted through agreements like convertible loan notes or employee share options will significantly dilute existing shares when the options convert. Fully diluted share calculations consider the exercise of conversion rights, helping determine the total number of shares a company would have if all these securities were converted. This calculation ensures a comprehensive view of the company’s capital structure and aids in evaluating ownership stakes.
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