If you already own a company, there are many reasons to issue shares. For example, you may start a share incentive scheme for employees, where you award options, sell or give your team members part-ownership of your business. Or you may decide to issue shares to investors as part of a financing, whether by venture capital/private equity investment, or by giving funders notes such as simple agreements for future equity (SAFEs), loans that are convertible into shares.
Whatever your reason for issuing new shares, the net effect can be to reduce the value of each investor’s shareholding. It also reduces the proportion of the ownership of the company by each investor. This is called share ‘dilution’ and can be unpopular with shareholders who may see both the value of their shares and their degree of control over the business fall.
In this guide, we take a look at share dilution in more detail.
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What are diluted and undiluted shareholdings?
A shareholding of a company is undiluted if there are no outstanding options or rights to acquire or purchase its shares.
For example, say a newly formed company issues 100 shares to its founders Claire and Bob on a 60/40 basis. Claire owns the company 60%, and Bob 40%. Claire has effective control over the company as she has a majority of the shares.
If that same company goes on to trade and grow, Claire and Bob may look to raise financing in return for a share of the company. They could issue shares immediately in exchange for funding, or the company could borrow money in return for an option to acquire shares in the future. In either case, Claire and Bob’s shares would be ‘diluted’ by any shares issued.
In the above example, let’s say Claire and Bob issue investor Alex with 20 shares. Now, Claire owns 60 out of 120 shares, Bob owns 40 and Alex 20. Claire has lost control of the company as she now owns 50% of the shares, as do Bob and Alex together. What’s more, the company is now potentially ‘deadlocked’, as no single shareholder can pass an ordinary resolution.
What is included in a company’s fully diluted share capital?
A company’s fully diluted share capital includes all issued shares, together with all rights to acquire shares in the future. This includes, at any point in time:
- All shares currently issued
- Shares to be issued to any third party. For example, to a new employee
- Share options granted to people like employees and directors that can be converted into common shares
- Shares to be issued to investors in return for additional capital contributed to the company in return for those shares. For example, in a financing round
- Shares to be given in exchange for other shares. For example, as part of mergers and acquisitions when shares in a target company are issued to shareholders of the acquiring company as part of the deal
Passing resolutions
Directors are sometimes given the power in the company’s articles of association to issue new shares. They can do this by passing a resolution of the Board of Directors. However, because issuing shares can cause dilution, the articles often prevent the directors acting alone, and require that the shareholders must agree to a new share issue in an ordinary resolution of the shareholders passed by the majority.
In addition, increasing the total number of shares available to issue, and creating a new class of shares can cause dilution. Because of this, the directors must get the prior consent of at least 75% of the shareholders in a special resolution. Special resolutions are needed where the company takes certain major decisions that can affect its future and thus its value.
Why is fully diluted share capital important for investment?
It’s important for investors and founders to understand the implications of fully diluted share capital because the total number of shares that are either already issued, or could potentially be issued in the future, represents the maximum potential for dilution.
If, prior to a financing, all parties know the full extent of this potential for dilution, they can agree a formula for valuing the company and decide how much each share should cost, as well as look at the impact on control.
This is particularly important where a company has granted share options to employees. Sometimes share options will ‘vest’ over a period of time or when certain milestones occur, after which point the employee has the right to purchase shares. This is known as a ‘vesting schedule’. Shareholdings can sometimes be substantially diluted when the employee exercises its right to shares.
What is scenario modelling?
Because both the degree of control over the company and the value of shares can be affected by dilution, founders and investors often carry out ‘scenario modelling’ to calculate the potential future effects. By using capitalisation or ‘cap’ tables, you can see the impact of various events and understand how the table will be affected by each round of investment and in any exit situation.
Example cap table
Investors typically provide a company with funding in return for shares. How much they pay for those shares depends on the value or potential value of the company, and how many shares have been issued or may be issued in the future. As cap table shows the effect of dilution, you can come up with a more accurate price for the investor shares and see the impact on control.
Here are sample cap tables both before and after a theoretical investment in Claire and Bob’s company, to show the effect of dilution:
Capitalisation table before new investment
| Shareholder | Ordinary Shares | Options | Fully Diluted | Percentage Fully Diluted |
| Claire | 7,500 | 7,500 | 48.38% | |
| Bob | 2,500 | 2,500 | 5,000 | 32.26% |
| Employee option pool | 1,500 | 1,500 | 9.68% | |
| SAFE notes | 1,500 | 1,500 | 9.68% | |
| Total | 10,000 | 5,500 | 15,500 | 100% |
Cap table summary
| Shareholder | Fully Diluted | Percentage Fully Diluted |
| Founders | 12,500 | 80.64% |
| Employee pool | 1,500 | 9.68% |
| SAFE notes | 1,500 | 9.68% |
| Total | 15,500 | 100% |
Cap table after new investment
| Shareholders | Ordinary Shares | Options | Fully Diluted | Percentage Fully Diluted |
| Claire | 7,500 | 7,500 | 42.86% | |
| Bob | 2,500 | 2,500 | 5,000 | 28.58% |
| Investor #1 | 1,000 | 1,000 | 5.71% | |
| Investor #2 | 1,000 | 1,000 | 5.71% | |
| Employee option pool | 1,500 | 1,500 | 8.57% | |
| SAFE notes | 1,500 | 1,500 | 8.57% | |
| Total | 12,000 | 5,500 | 17,500 | 100% |
Cap table summary
| Shareholder | Fully Diluted | Percentage Fully Diluted |
| Founders | 12,500 | 71.43% |
| Investors | 2,000 | 11.43% |
| Employee pool | 1,500 | 8.57% |
| SAFE notes | 1,500 | 8.57% |
| Total | 17,500 | 100% |
You can see from the above example, that after the investment, Claire and Bob have lost the ability to pass a special resolution of the company acting together, as they now own less than a 75% share.
