In a deal recently, the term sheet offered by the prospective investor contained a reference to the term: "fully-diluted". The company accepted the term sheet and the lawyers drafted the documents. On review by the Company, however, it became clear that the parties had different interpretations of "fully-diluted". Due to some idiosyncracies of the company's capital structure, the disagreement had a significant impact on the deal structure.
While that deal recovered and closed, it highlights the need for entrepreneurs and investors to understand when so-called defined terms like "fully-diluted" actually need explicit definition in the term sheet.
The term "fully-diluted", unlike some legal terms, is not defined by any law or regulation. That is, there isn't any place to go "look up" what it means. This, plus the informal way the term is used in venture financings, puts a premium on the parties explicitly agreeing to a commonly-understood definition.
In general, the term "fully-diluted" attempts to capture the notion of how many shares of Common Stock would be outstanding if all securities of the company that either (1) are outstanding or (2) are available for the board to grant or issue actually become Common Stock in accordance to their terms. This "fully-diluted" number is sometimes called "common stock equivalents".
In essence, there are two kinds of securities that need to be considered in fixing the number of "fully-diluted" shares: (1) outstanding common stock and (2) so-called "deriviative securities". Many different securities can fall into this latter category, but usually in a startup company situation, there are the following 3 - 4 types:
- Stock options (or "warrants", which are exactly the same thing, only called by a different name) that are actually granted;
- Stock options that are reserved for future issuance by agreement among the company and the investors (various consequences occur if this number is exceeded, most commonly an antidilution adjustment to the effective "as-if-converted" price of the Preferred Stock);
- Convertible promissory notes, which are frequently used in seed financings, and which convert into (usually) the series of Preferred Stock issued in the company's next financing;
- Preferred Stock, which is usually the security issued in VC financings, and which converts in certain circumstances into Common Stock.
In this situation, the maximum, fully-diluted number of shares outstanding would be calculated by counting the number of outstanding shares of Common Stock, as well as assuming all the following had occurred and been added together :
- The number of shares of Common Stock that would be outstanding if all stock options (and/or warrants) were fully exercised
- The number of shares of Common Stock that would be outstanding if all stock options reserved for future grant were actually granted and fully exercised
- The number of shares of Common Stock that would be outstanding if all outstanding convertible promissory notes were converted into (usually Preferred) stock and that Preferred Stock was then converted into Common Stock
- The number of shares of Common Stock that would be outstanding if all outstanding shares of Preferred Stock were converted into Common Stock
There can be other, more complex securities (e.g. certain kinds of so-called "exchangeable securities) that also need to be considered in certain situations. The key to avoiding disagreements is to make sure that the parties have a common understanding of the types of "derivative securities" that are outstanding (or could be pursuant to current agreements), and that they agree on which of them gets counted as part of determining the "fully-diluted" number.