Fully Diluted . . .

is a phrase with more than one meaning that is frequently used by private company investors to express how they are computing the valuation of a company in which they are proposing to invest. The term often first appears in an investor's term sheet in defining the value the investor places on the company for investment purposes. For example, and investor might provide that it will purchase $5 million worth of company stock at a post money valuation of $25 million on a "fully diluted" basis. Often, the term is not more fully defined until the actual financing agreements are drafted.

Fully diluted refers to the number of shares a company will be considered as having issued for the limited purpose of determining how many shares of stock an investor will acquire. In the preceding example, if the company has 4 million shares on a fully diluted basis, the investor's $5 million dollars would purchase enough shares so that after the investment the investor owned 5/25ths of the company's stock. In this case, the investor would acquire 1 million shares which would equal 5/25ths or 20% of the company's 5 million shares of stock outstanding after investment. If, instead, the phrase "fully diluted" is defined to include more shares, say 6.25 million instead of 5 million, the investor would acquire 1.25 million shares so that his 1.25 million shares would represent 1.25 million of 6.25 million shares or 5/25ths of the company's shares after the investment.

As illustrated above, the manner in which "fully diluted" is defined directly effects how many shares a company must sell to raise capital. Elements included in a definition of "fully diluted", in order of descending frequency of appearance, are:

• shares of a company's capital stock that have been issued to and are still held by the company's shareholders;

• shares of a company's capital stock that have not yet been issued but which can be purchased under outstanding options or warrants that have been issued by the company;
  

• shares of a company's capital stock that have not yet been issued but can be acquired upon conversion of existing rights to convert debt or other rights, as in shares a lender can acquire under a contract that lets it convert some or all of its debt into stock;
  

• shares of a company's capital stock that have not yet been issued but have been reserved (and are therefore available) for issuance to company employees under a company stock plan but which have not been issued or committed to employees by the issuance of options, warrants or other stock plan grants;
  

• shares of a company's capital stock that have not yet been issued but are reserved (and are therefore available) for issuance to identified future business partners upon completion of anticipated business deals;
  

• shares of a company's capital stock that have not yet been issued but are expected to be needed to complete business deals in the future; and,
  

• any other shares that might be issued in the future.

Obviously, the more shares and prospective future shares an investor can throw into a definition of "fully diluted", the more shares the investor will receive for an investment he proposed to make that is based of a fixed, fully diluted valuation of the company. Consequently, a company's management is wise to consider the meaning given to this term in an investor's offer before agreeing to the proposal. Two ways to improve a proposed valuation are to increase the amount of the valuation given to the company and to reduce the scope of what "fully diluted" is defined to mean. See: Fair Market Value, Financing Agreements, Letters of Intent, Offering Memorandums, P/E, Price-Earnings Ratio, Pricing, Term Sheets, Valuation.