What is dilution? What is a fully-diluted cap table?

Dilution refers to a decrease in an owner’s percentage interest in the company.  If there are 4 million shares outstanding and you hold 1 million shares, that equates to 25% of the outstanding stock.  If the company issues another 1 million shares, your percentage ownership drops to 20%, and you have been diluted 5%.  Similarly, when stock options or warrants are exercised, existing shareholder are diluted.

A “fully-diluted” capitalization table shows, in addition to all outstanding shares, the number of shares (or units) issuable upon exercise or conversion of the contingent equity.  Sometimes the exact number of shares can not be determined.  For example, if the the number of shares issuable upon exercise of a warrant may be based on a formula, such as a percentage of gross sales.  In such cases, a properly prepared fully-diluted cap table will have footnotes explaining the assumptions underlying the share numbers shown.  

Also, with respect to employee stock options, there should always be a footnote on the cap table indicating which calculation is used, because there three possible meanings of “full-dilution” in the case of employee stock options.  The three ways to record the the number of stock option shares, starting from largest to smallest, are:  (1) the total number of option shares authorized by the stock option plan, (2) the total number of options currently granted, and (3) the total number of options currently vested.  Number (1) is used most often and is the most conservative number for management to use.  Number (2) makes sense if additional options are not likely to be granted for some time, but the cap table should clearly indicate that only granted shares are shown.  Number (3) is rarely used, since options will continue to vest as long as employees stay employed, but in certain cases, for example when there is a long period before the next options vest,  it may make sense to include an additional column in the cap table showing vested only options.

Sometimes the term dilution is used in reference to dilution of value, as opposed to dilution of percentage interest.  If new shareholders are paying a fair price for their shares, then the value (as opposed to ownership percentage) of existing shareholders’ interests are not being diluted.  In general, I would recommend not using the term dilution (or lack thereof) in this way, but you should be aware when others use it in that sense.  See “What are anti-dilution protective covenants?“.

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