Congratulations, you received a term sheet! While the main terms, such as valuation, are certainly important, there are numerous less noticeable terms that can have just as great an impact. One such term is “fully-diluted”.
What is a fully-diluted calculation?
A fully-diluted calculation assumes that all options, warrants and other rights to acquire stock have been exercised or converted, regardless of whether they are actually vested or exercisable at the time of the offering.
Let’s illustrate the impact of a fully-diluted calculation compared to a funding round without full dilution.
Startup has issued 1,000,000 shares and 100,000 options. None of the options are vested. Investor desires to take 10% interest in the company.
Not fully-diluted: Startup will use the number of issued shares only to calculate the 10% and will issue investor 111,100 shares (representing 10%).
Fully-diluted: Startup will use the total number of issued shares and options to calculate the 10% and issue the investor 122,200 shares. However, since none of the options are vested, and may never vest, investor actually acquired a present-day interest of 10.89%.
While the above example seems benign given the .89% difference, that percentage could be worth a large sum if the company exits in the future. What if you are selling an almost controlling interest in the company, perhaps 23.5%? In that case, a fully-diluted calculation could result in a sale of a 25%+ (and controlling) present-day interest depending on the number of outstanding options etc. In other situations, an investor may request that the entire option pool (even if no options have been granted) be factored into the fully-diluted calculation – in the case of a 12% option pool, this term would have a substantial impact.
In sum: while you may not be able to avoid a fully-diluted calculation in a term sheet, it’s important to understand its impact and to negotiate with that impact in mind.