editione1.0.1Updated 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.
exampleLet’s look at the difference in the two approaches using our cap table from our scenario A example just above, where the Round 1 investors are buying 20% of the company for $250K at a $1M pre-money.
|Shares or Options||Issued and Outstanding||Fully Diluted|
|Issued and Outstanding||10,345,000||100.00%|
|Total Fully Diluted||11,500,000||100.00%|
Using the fully diluted basis, the price per share is $1M/11,500,000 or $.087 per share. When this company IPOs at $17 per share, you’ll have a 20X return! Checking the math, 2,875,000 shares purchased by the investors (see the post investment cap table in Figure A1) at $.087 each is $250K.
If the investment was instead defined as 20% ownership post investment based on the issued and outstanding shares, the price would be calculated as $1M/10,345,000 = $.097 each. The shares are more expensive, and so the investors only receive 2,586,385 shares for their $250K. That’s 288,615 fewer shares, or roughly 10% less.
importantAs an investor, you clearly want to use as large a pre-investment share total as possible in calculating the price per share (large denominator), so you want the price per share based on the fully diluted calculation. And pay attention to the definition of fully diluted, as it can vary.
As we saw in the pricing discussion above, the difference between a calculation based on issued and outstanding shares versus fully diluted shares can be significant. The option pool is typically the biggest component of the difference between issued and outstanding and fully diluted shares, and so the size of that option pool tends to get a lot of scrutiny at the time of any investment.
As a company hires employees, it issues grants of options on the stock that is reserved for the stock option pool, thereby slowly depleting that pool. It is common that a company has to top up its stock option pool several times as it grows from no employees to dozens, to hundreds, to potentially thousands. It increases the pool by allocating shares from the company’s authorized stock. When the company adds more shares to the option pool, it dilutes all the existing stockholders (when using the fully diluted ownership calculation). It is a round of dilution without directly bringing in any money (the way a stock sale to investors does). So companies aren’t anxious to top up the pool by themselves.
Savvy investors know that the company should have a healthy stock option pool so it can motivate the new employees it wants to hire with the money it is raising. So as part of almost any priced investment round there is a discussion about how big the pool should be and who is going to take the dilution hit. New investors want to allocate additional shares to the pool in a way that dilutes the existing equity holders before the new investors come in. The company would prefer if the option pool were topped up after the new money came in, as the dilution to the founders and prior investors would be less because the new investors would be sharing in that dilution.