Fully Diluted

What does fully diluted mean?

Fully diluted (German: voll verwässert) refers to a way of counting that, besides the issued company shares (Geschäftsanteile), also counts all rights from which shares or claims to proceeds may later arise. These rights are treated as if they had already been exercised or converted. The result is the fully diluted basis, that is, the total number of shares to which ownership percentages and the price per share of a funding round are related. The shares counted in this way are also called fully diluted shares.

It is comparable to planning a party: all guests who have accepted are counted, including those who are not yet in the room.

Fully diluted is not a statutory category but a contractual definition. It appears in the term sheet, in the participation agreement, in convertible loan agreements and in the terms of virtual participation programmes, and each of these definitions may be worded differently. For a GmbH (German limited liability company), the legally decisive record of ownership remains the shareholder list (Gesellschafterliste); the fully diluted basis supplements it with the economic view.

Three entries are closely connected. Fully diluted is the counting rule. The fully diluted cap table allocates to each holder their shares according to this rule, and the fully diluted valuation multiplies all shares counted in this way by the price per share.

What belongs to the fully diluted basis

Which rights are included is set by the respective definition. In German funding rounds, the following are usually included:

• Issued company shares of all shareholders, regardless of whether preferential rights attach to them.
• Allocated virtual shares and options from the employee programme (ESOP), whether or not they have vested yet. Shares not yet earned count too, because they are earned under the vesting plan if the person continues to work for the company.
• The unallocated pool, that is, shares reserved for future commitments to employees but not yet promised to anyone. Investors insist on it because these shares would otherwise be issued to their detriment after they come in.
• Conversion rights from a convertible loan and comparable instruments, recognised at the number of shares that would result on conversion (as converted, that is, as if conversion had already taken place).
• Option rights of third parties, for example of a provider of growth loans (venture debt) or an adviser, that entitle them to acquire company shares.

Formula: Fully diluted basis = issued company shares + allocated virtual shares and options + unallocated pool + shares from conversion rights + option rights of third parties

A shareholder's fully diluted percentage is their number of shares divided by this basis.

What is not included

Authorised capital does not count. This means an authorisation of the management in the articles of association to increase the share capital up to a maximum amount without a new shareholder resolution (Section 55a of the German Limited Liability Companies Act, GmbHG). As long as it is not reserved for specific commitments, it remains a mere possibility. Lapsed virtual shares count only if they fall back into the pool under the plan, and then only once. The company's own shares (treasury shares) are usually left out. Exit bonuses promised as a fixed amount do not belong in the share basis; as a deduction item, they reduce the proceeds distributed among the shares. Compensation shares from anti-dilution protection are included only once a round triggers them.

Virtual shares: economic rather than legal

Virtual shares are not company shares. They establish a contractual payment claim against the company, confer no voting right and do not appear in the shareholder list. When paid out, they are employment income for the employees. Economically, however, they are equivalent to shares, because the payment is measured by the proceeds per share. Every virtual share reduces the amount attributable to a company share at the exit. Investors therefore count them in the fully diluted basis, although legally they are a liability of the company.

A base price, that is, an amount per share deducted from the later payment to the employees, is usually disregarded here. The basis counts every virtual share in full, even if the later payment covers only the value above the base price. For the price of a round, this is a simplification in favour of the new investors, because a larger denominator lowers the price per share. In the distribution of proceeds at an exit, by contrast, the base price is accounted for precisely (strike price).

Conversion rights: calculating with assumptions

With a convertible loan, the number of conversion shares is only fixed once the conversion price is fixed. If the loan converts at a discount to the round price, the number depends on the price. The price in turn depends on the share basis into which the conversion shares flow. This mutual dependence can be solved as an equation or calculated in a spreadsheet with iteration (step-by-step approximation).

Some agreements provide for a valuation cap, that is, a maximum valuation for the conversion. If it lies below the valuation of the round, the conversion price follows the cap. The cap, too, relates to a share basis, however, and the loan agreement must specify which. For planning purposes, the conversion is therefore modelled in scenarios: at the cap, at the expected round price with discount, and at a cautious lower price.

Fully diluted in a funding round and a company sale

In the funding round, the fully diluted basis determines the price per share. The pre-money valuation, that is, the value before the inflow of new capital, is divided by the number of shares existing on this basis before the round. The more rights are included, the lower the price per share turns out and the less the existing shareholders' shares are worth at the round price. Commitments to investors, too, mostly refer to this basis, for example a stake of 20% after the round or the right to participate pro rata in future rounds.

In a company sale, the purchase price for the equity is distributed, after any prior claims of the investors (liquidation preferences) have been satisfied, among the shares that actually participate in the proceeds. This is not exactly the basis of the funding round: unallocated pool shares generally receive nothing, and for virtual shares the base price is deducted. The basis must nevertheless be complete. Acquirers and investors therefore check in due diligence whether all commitments have been captured. Frequent gaps are commitments in employment or adviser agreements, in side letters with investors or in emails to employees that were never carried into the participation plan.

Worked example: calculating fully diluted shares and percentages

A GmbH has 64,000 shares with a nominal amount of EUR 1 each, 40,000 of them held by the founders. From the virtual programme, 7,000 shares are allocated, 3,000 of them vested. A further 3,000 are reserved but not allocated, including 1,500 shares that have fallen back into the pool from departed employees. A convertible loan yields 5,000 shares on conversion at the valuation cap, and a venture debt provider holds an option right to 1,000 company shares. The articles of association contain authorised capital of EUR 8,000 without a specified purpose.

• Fully diluted basis: 64,000 + 7,000 + 3,000 + 5,000 + 1,000 = 80,000 shares
• Not counted: the authorised capital; the 1,500 shares that fell back are already included in the 3,000 unallocated shares and are not counted twice
• Vesting status has no influence: the 4,000 shares not yet vested count just like the 3,000 vested ones
• Founders' percentage: according to the shareholder list 40,000 / 64,000 = 62.5%, fully diluted 40,000 / 80,000 = 50%
• A new investor is to hold 20% fully diluted after the round: it needs 80,000 × 20 / 80 = 20,000 new company shares
• If only the company shares are used for the calculation, 20% by contrast gives 64,000 × 20 / 80 = 16,000 new company shares. Fully diluted, the investor would then hold only 16,000 / 96,000 = about 16.67%
• With an investment of EUR 4 million, the first definition corresponds to EUR 4 million / 20,000 = EUR 200 per share, the second to EUR 4 million / 16,000 = EUR 250 per share

The same commitment of 20% leads, depending on the definition, to a difference of 4,000 company shares and a price per share that differs by EUR 50, although both calculations amount to the same pre-money valuation of EUR 16 million (EUR 200 × 80,000 or EUR 250 × 64,000). Which basis is meant should therefore be set out already in the term sheet.

Distinctions: fully diluted, undiluted basis and dilution

• Undiluted basis: counts only the issued company shares and thus corresponds to the percentages in the shareholder list. It determines voting rights, but not the economic share of the proceeds.
• Dilution: the decline of a percentage through new shares or share rights. Fully diluted is the basis on which this decline becomes fully visible.
• Fully diluted cap table: the tabular presentation of the fully diluted basis by shareholder and instrument, usually supplemented by a pro forma calculation showing the position after the upcoming round.
• Fully diluted valuation: the valuation of a round as an amount in euros. Fully diluted supplies the number of shares, the valuation multiplies it by the price per share.
• Diluted earnings per share: a key figure of listed companies under the international accounting standard IAS 33. For options, only as many additional shares are included there as remain after a notional buy-back with the exercise proceeds (treasury stock method). In funding rounds, by contrast, share rights are counted in full.

Common mistakes

• Definition left open. If the term sheet says only “fully diluted”, it remains unclear whether the unallocated pool, conversions and option rights of third parties are included. The difference then only shows up in the contract drafts.
• Unearned shares excluded. Anyone who counts only vested virtual shares underestimates the basis. Investors calculate with all allocated shares.
• Fallen-back shares counted twice. Shares that fall back into the pool easily appear both with the departed employee and in the free pool. The basis is then too large and the price per share too low.
• Commitments outside the plan overlooked. Promises in employment contracts, adviser agreements or side letters count economically. If they only become known in due diligence, they shift price and percentages.
• Conversion calculated with only one price. The number of conversion shares depends on the round price. Planning with only one assumed price hides how strongly the basis grows at a lower valuation.
• Authorised capital counted. A mere authorisation to issue new shares is not a commitment. If it is counted, the price per share falls without any substantive reason.

Frequently asked questions

What are fully diluted shares?

The total number of shares on a fully diluted basis: issued company shares plus all rights from which shares or claims to proceeds may still arise. In the worked example, that is 80,000 shares, although the shareholder list shows only 64,000 company shares.

Do shares not yet vested and the free pool count?

As a rule, yes. Allocated virtual shares count regardless of the vesting status, because they are earned if the person continues to work for the company. New investors require the unallocated pool in the basis so that later allocations do not reduce their percentage; the definition in the term sheet should regulate both expressly.

Are virtual shares equity?

No. Legally, they are contractual payment claims against the company, which for the employees are employment income when paid out. They enter the fully diluted basis because economically they participate in the proceeds like shares.

Can the fully diluted basis be reduced before a round?

Yes, for example by cancelling pool shares that are not needed or by clearing up lapsed commitments. Whether this benefits the existing shareholders depends on whether the new investor in any case requires a pool of a certain size after the round; the cancelled part must then be topped up again.

The Roemer Capital view

Roemer Capital assembles the fully diluted basis at the very start of a mandate from the source documents: shareholder list, participation plan with all individual commitments, convertible loan and financing agreements. Discrepancies between these documents are clarified with the company and its law firm before an investor finds them in due diligence.

In the term sheet, Roemer Capital makes sure that the definition expressly states which rights count. It then applies the same definition to every calculation, from the price per share to the distribution of proceeds, so that offers from different investors remain comparable.