Share Calculation on a "Fully-Diluted Basis"

Most seed or series financings calculate the preferred stock share price paid by the investor on a "fully-diluted basis."FN1 This sounds like math but really it's basic, macro-level accounting.

The underlying principle is this: the determination of how many shares the investor receives for the money he's investing is a proxy for something more crucial: the investor's percentage ownership of the company.

The investors have an incentive to capture as much percentage ownership as possible and thus have an incentive to capture as many shares as possible. "Fully diluted basis" means that the investor's proposed percentage ownership of a company be calculated against the absolute TOTAL number of shares outstanding in the company - the "basis".

The reason this matters, and why the terminology is often embedded in legal documents, is that often at the time of a seed or series financing there is outstanding stock that gets overlooked. This stock has been effectively but not technically issued - in the form of unexercised stock options, warrants, convertible debt and the like. The calculation of what's included in the basis determines who will assume the future diluting effect of any stock that is not exercised at the time of the financing (but almost surely will be at a later date).

If the basis calculation includes unexercised stock, then at the time of the financing the existing common stock holders (i.e., founders) - but not the investors - are, in effect, diluted. If the calculation doesn't, then when the stock is eventually exercised, all the existing stock holders, including investors, share pro rata in the dilution effect. For example:

Pre-financing Company has issued 5 shares of common stock but also has unexercised debt and stock options convertible into a total of 3 shares of common stock. Investor wants 50% ownership. If basis does not include the unexercised securities, investor gets 5 shares. If basis does so include, then investor gets 8 shares (for the same amount of money invested).

So, that's the concept. Mechanically, the calculation works on the level of the share: the larger the basis the less the investors will have to pay per share of the preferred stock. This is a function of the oft-cited formula: per share price = pre-money valuation / total outstanding shares.

FN1. “Fully-diluted” capitalization typically means (i) all issued (outstanding)  common stock, (ii) all issued (outstanding) preferred stock, (iii) any issued (outstanding) warrants, (iv) all issued (outstanding) options, (v) options reserved for future grant, and (vi) any other convertible securities. In essence, the only category of stock that is not counted in this fully-diluted capitalization number is the stock that is "authorized" in the Articles of Incorporation but as yet not issued.