What it means
Most companies have more claims on their equity than the share register suggests. Employee share options, warrants issued to lenders, convertible notes and shares set aside in an unallocated option pool all represent shares that do not exist yet but may well exist soon.
Counting only issued shares therefore overstates each existing holder's true stake. The gap can be substantial.
A venture-backed company with a 15% option pool and a convertible loan can easily have a fully diluted count 25% or more above its basic count, which means a founder told they own 30% may actually own closer to 24% on a fully diluted basis. In share sales and funding rounds, ownership percentages are almost always negotiated on the fully diluted number for exactly this reason.
Reported earnings per share reflects the same idea. Companies publish both basic earnings per share, using the weighted average of shares actually issued, and diluted earnings per share, which includes the effect of options and convertibles that would reduce the per-share figure.
Diluted earnings per share is the more conservative and generally the more useful number. Accounting standards apply a refinement called the treasury stock method for options.
Rather than adding every option as a whole share, it assumes the exercise proceeds are used to buy shares back at the market price, so only the net increase counts. Options priced above the current share price are excluded altogether because exercising them would make no sense.
The distinction between the accounting number and the negotiating number catches people out. Accounts exclude out-of-the-money options, whereas a buyer or investor pricing a deal usually counts the entire pool, in-the-money or not, because those shares can dilute them later.
Always ask which definition is being used before agreeing a percentage.
In practice
Real-world examples.
Example
A founder negotiating a funding round is offered terms preserving her at 32% ownership. She insists the calculation runs on a fully diluted basis including the enlarged option pool, which reveals the real figure is 27%.
Example
A listed manufacturer issues a $50,000,000 convertible bond. Analysts immediately recalculate diluted earnings per share, assuming full conversion, and the shares fall slightly as the market absorbs the potential dilution.
Example
An acquirer buying a private company for $84,000,000 divides the price by fully diluted shares rather than issued shares. The per-share price falls from $4.20 to $3.50, and the founders negotiate to have unvested options excluded.
Think of it
“Fully diluted shares count everything that could become stock-including options and convertibles.
Formula
Calculation
Fully diluted shares = basic shares outstanding + shares from options + shares from warrants + shares from convertible instruments
Take a growing software business:
Basic shares outstanding: 20,000,000
Employee options granted and unallocated pool: 2,000,000
Warrants held by a lender: 500,000
Convertible note converting into: 1,500,000
Fully diluted shares = 20,000,000 + 2,000,000 + 500,000 + 1,500,000 = 24,000,000.
Now see what that does to earnings per share. With net income of $12,000,000, basic earnings per share is $12,000,000 / 20,000,000 = $0.60, while fully diluted earnings per share is $12,000,000 / 24,000,000 = $0.50. The reported profit has not changed by a cent, yet the per-share figure is about 17% lower. A founder holding 5,000,000 shares owns 25% on a basic count but 5,000,000 / 24,000,000, or roughly 20.8%, fully diluted.Case study
Seen in the real world.
Tannerbrook Analytics is a fictional business used for this illustrative example. Its two founders each believed they owned 35% of the company, with investors holding the remaining 30%, and they had been managing the business on that basis for three years.
When a trade buyer offered $60,000,000, the lawyers produced a fully diluted capitalisation table. Alongside 10,000,000 issued shares there were 1,800,000 granted employee options, an unallocated pool of 700,000 and a convertible bridge loan that would turn into 1,500,000 shares on a sale, giving 14,000,000 fully diluted shares. Each founder's 3,500,000 shares therefore represented 25%, not 35%.
The difference was roughly $6,000,000 per founder, and it arrived as an unwelcome surprise a fortnight before signing. In this illustrative account the deal completed, but the founders afterwards required their finance team to maintain a fully diluted capitalisation table reviewed every quarter, so that ownership was never again a matter of memory.
Watch out
Common mistakes.
- Quoting an ownership percentage from the share register when every serious negotiation uses the fully diluted count.
- Forgetting the unallocated option pool, which is the single most common reason a founder's actual stake is lower than expected.
- Assuming reported diluted earnings per share captures all potential shares, when out-of-the-money options are excluded from the accounting figure.
Questions
People also ask.
Is fully diluted the same as diluted earnings per share?
Not exactly, since the accounting figure applies the treasury stock method and excludes options that are out of the money, while a fully diluted count for a deal typically includes them.
Does dilution reduce the value of my shares?
It reduces your percentage of the company, though if the money raised or the talent retained grows the business enough, a smaller slice of a larger business can still be worth more.
Where do I find fully diluted shares for a listed company?
The share capital and earnings per share notes in the annual report set out the potential shares from options, warrants and convertible instruments.
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