Fully diluted - what it means and how it affects valuation

Posted by Alexander Goertz

September 2016

The term “fully diluted” comes into play when founders and VCs negotiate a financing round. It is important to understand the meaning of this term and its economic impact on the deal. Also, you should make sure that both parties have the same understanding of this term – which, unfortunately, is not always the case. It can really slow down, or even stop, a deal if the parties think they have a fully negotiated term sheet but later, when the detailed documentation is drafted, find out that they had misunderstood one another and had not actually agreed on this economic factor.

When negotiations of a financing round start, the parties often focus on the “pre-money valuation”. That is the value of the startup before the investment is made and therefore an important factor. Usually, the pre-money valuation is agreed on a “fully diluted basis”, which means that the value per share is determined considering not only any existing shares but also all shares that are promised or granted to employees, consultants, business partners and financial institutions, e.g. under an employee stock option plan (ESOP) or a convertible loan instrument. An investor makes the investment assuming that all of these options will actually be exercised and therefore determines the purchase price on this basis. Consequently, any dilution resulting from these options will be borne by the founders.

Why do investors take up this position? If asked, they would probably argue that their valuation is based on the assumption that the startup will reach its projected targets. However, to do so, the startup will have to attract talented employees, consultants, etc. and offer them strong incentives – i.e. shares granted under an ESOP. After all, such incentives are market standard and a refined business plan should include the granting of such incentives as part of the projected personnel costs. Any costs from or, the economic effect of, such ESOP must therefore – in the reasoning of the investors –be borne by the existing shareholders (i.e. in a first financing round, the founders). This results in a valuation adjustment to the benefit of the investors as lowers the share price, as the following example shows:

Let’s say the startup has a share capital of €25,000.00 divided into 25,000 shares. The founders and the investor agree on a pre-money valuation of €4m (= €160/share). The investor would like to invest €2m, resulting in a post-money valuation of €6m.

Without any dilution, the investor would receive 12,500 new shares (= a 33.33% shareholding). However, the investor requests a 10% ESOP to be established either before or immediately after he made the investment and that such ESOP to be reflected in the cap table as a prerequisite for the financing round. A 10% ESOP represents a value of €600,000 (10% of the €6m post-money valuation). Taking this into account, the fully diluted share price is calculated as follows:

Share price on a
fully diluted basis
= pre-money valuation
- costs of ESOP
number of existing shares
= €3.4m
= €136.00/share


Based on this fully diluted share price, an investment of €2m would buy the investor roughly 14,706 new shares (€2m / €136). Following the investment, the startup would have a total of 39,706 shares, of which 25,000 are held by the founders (= 62.96%), and 14,706 are held by the investor (= 37.04%). The size of the ESOP will be 4.412 shares (€ 600,000.00 / 136.00). If the ESOP becomes fully vested, the employees will hold 10%, the investors will hold 33.33% and the founders’ shareholding will be diluted to 56.67%.

Founders can find this particularly harmful if the stock options granted are subject to an exercise condition that may never occur (e.g. employees leaving the company before their options become vested). A calculation on a “fully diluted basis” will not consider this factor and the investor would benefit from this effect (i.e. end up having a higher shareholding than anticipated). Therefore, before you as a founder grant a stock option or a warrant, be aware that even if such grants are not eventually exercised, they may still dilute your shareholding if the share price is calculated on a fully diluted basis. However, if you plan wisely, this scenario should be the exception – remember that e.g. unvested share options of an employee that is leaving the company will be granted to the successor or can be given to the remaining team.

VCs, on the other hand, will try to minimize their risk of future dilution by making the ESOP pool as large as possible upfront. Founders can react to this in two ways:

1. fight the ESOP size - this can be a viable option if e.g. the founders can show that, according to their business plan, they will be able to reach their milestones with a smaller team and therefore a smaller-sized ESOP; or

2. try to negotiate a higher pre-money valuation.