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founder It is useful for both entrepreneurs and investors to understand the mechanics of dilution, how dilution and ownership are calculated, and how the cap table will be impacted by investment.
Dilution is the decrease in ownership percentage of a company that occurs when the company issues additional stock, typically for one of the following reasons: to issue to a co-founder who came on after incorporation, to sell to investors, or to add to its stock option pool.
When a company is formed, the certificate or articles of incorporation states the total number of shares the company is authorized to issue, called authorized shares. If the company decides it needs more shares at some point, it will need to amend its certificate or articles of incorporation, and that typically requires approval of a majority of stockholders. Authorized shares can include common stock and preferred stock.
Issued and outstanding shares are the shares that have been issued to founders, employees, advisors, directors, or investors. Issued and outstanding shares do not include stock options that have been reserved in the option pool. Ownership percentage calculated on an issued and outstanding basis is determined by dividing the number of shares owned by an individual or entity by the total issued and outstanding securities.
Fully diluted shares take into account all issued and outstanding shares on an as-converted to common stock basis, assuming the conversion or exercise of all convertible securities, such as options, warrants, and convertible preferred stock. Sometimes fully diluted shares take into account not just issued options but the entire stock option pool share reserve. Investors prefer that the price per share be determined on a fully diluted basis because increasing the number of shares in the denominator in the formula above reduces the price per share.
Considering that a stock option pool can represent 15% or 20% of the shares of a company, the ownership difference resulting from the two definitions can be substantial.
If you are calculating dilution based on the number of issued and outstanding securities, then each time part of the stock option pool is allocated to an employee in the form of a stock option grant, your ownership percentage goes down slightly, since there are now more issued and outstanding securities (the additional stock options). If you are calculating dilution on a fully diluted ownership percentage (or simply put, a fully diluted basis), counting the entire option pool, then your ownership percentage doesn’t change, since all of the stock options, either allocated to employees or not, were already in the denominator.
When a company hires an employee and gives them stock options as part of their compensation, they usually issue the options out of the company’s stock option plan (not the company’s authorized but unissued shares).