Dilution From Adding an Employee

From

editione1.0.1

Updated September 19, 2022

You’re reading an excerpt of Angel Investing: Start to Finish, a book by Joe Wallin and Pete Baltaxe. It is the most comprehensive practical and legal guide available, written to help investors and entrepreneurs avoid making expensive mistakes. Purchase the book to support the authors and the ad-free Holloway reading experience. You get instant digital access, commentary and future updates, and a high-quality PDF download.

When a company hires an employee and gives them stock options as part of their compensation, they usually issue the options out of the shares reserved for issuance under the company’s stock option plan (not the company’s authorized but unissued shares).

Joe and Pete hire a very experienced head of marketing and give them a stock option to purchase 3% of the company.

To translate the 3% of the company into a number of shares, Pete and Joe multiply 3% by the company’s issued and outstanding shares plus its entire stock option pool reserve. They are calculating the ownership on a fully diluted basis. This way, if they issue 3% to another executive the next week, that executive would get the same number of shares. Effectively, you don’t want each employee to dilute the next employee, especially since the board of directors may be approving option grants to five employees at the same time. This is how most companies translate negotiated percentages into share numbers; it does not have to be done this way, but it is the most common way.

Figure 3: First Employee Stock Option

Picking up from Figure 2A, the first employee is granted an option to purchase 345,000 shares (3% multiplied by 11,500,000), which represents 3% of the sum of the issued and outstanding shares and the entire stock option pool reserve.

Shares or OptionsIssued and OutstandingFully Diluted
Pete5,100,00049.30%44.35%
Joe3,400,00032.87%29.57%
Rachel1,500,00014.50%13.04%
Employee 1345,0003.33%3.00%
Issued and Outstanding10,345,000100.00%
Option Pool Available1,155,00010.04%
Total Fully Diluted11,500,000100.00%

345K shares were issued out of the option pool for Employee 1, the marketing director, which had several impacts (compare to Figure 2A):

  • It decreased the remaining option pool, which now represents a smaller percentage of shares.

  • It increased the total number of issued and outstanding shares and securities convertible into shares, which diluted all existing shareholders when their ownership is measured as a percentage of issued and outstanding securities.

  • It did not change the fully diluted ownership (which includes the option plan in the denominator) of the existing shareholders, because those shares were already in the option pool.

If you found this post worthwhile, please share!