What is Fully Diluted Capital and why does it matter in investment rounds?

What is Fully Diluted Capital and why does it matter in investment rounds?

In the context of corporate transactions and, in particular, in investment rounds in startups and growth companies, it is common to find references to the concept of “fully diluted capital”. Despite its recurrent use in documents such as term sheets, shareholders’ agreements and investment documents, its definition and practical consequences may raise doubts, even among legal and financial professionals.

“Fully diluted capital” refers to the total number of shares or equity interests that a company would have if all conversion, subscription and option rights available at any given time were exercised.

This includes:

• Shares issued and outstanding.
• Options granted to employees (stock options).
• Shares reserved in incentive plans.
• Convertible units (such as convertible notes or SAFEs).
• Warrants or other financial instruments convertible into equity.

In other words, “fully diluted capital” represents the maximum potential share capital, assuming that all convertible instruments have been exercised, regardless of whether or not they are currently exercisable.

During an investment round, investors not only analyze the existing equity capital, but also what their effective shareholding percentage will be considering future dilutions. The use of fully diluted capital as a basis for calculation makes it possible to realistically determine what shareholding they will obtain after the investment.

From a legal perspective, fully diluted capital has multiple consequences:

1. Negotiation of the percentage of equity: shareholder and investment agreements usually state that the percentages of ownership will be calculated on a fully diluted basis. Failure to take this basis into account can lead to misunderstandings or even disputes between shareholders and investors.
2. Corporate control: when special rights are negotiated (e.g., veto rights, enhanced quorum or appointment of directors), fully diluted capital is the appropriate benchmark for establishing thresholds. Otherwise, certain rights with less real weight in the capital could be activated.
3. Incentive plans: stock option plans usually set aside a percentage of fully diluted capital, thus ensuring that their impact is already foreseen at the time of investment and does not generate unexpected subsequent dilution.
4. Anti-dilution clauses: in many investment rounds, anti-dilution protection mechanisms are included that work on the basis of the calculation on fully diluted capital. This guarantees that the investor maintains its effective participation even in the event of future issues of convertible instruments.

That said, to avoid conflicts and ensure transparency in corporate transactions, it is essential to expressly define the term in contracts and agreements, to include a detailed cap table reflecting not only the issued capital, but also all convertible instruments and their impact on the shareholding structure, to have specialized legal and financial advice in each round to ensure that the percentages are calculated correctly and that the implications of fully diluted capital are properly understood.

Fully diluted capital is not simply a formula, it is a key tool to reflect the actual and future share capital structure of a company. Ignoring its importance or applying it incorrectly can generate significant imbalances between founding shareholders, employees and investors, affecting the governance, valuation and legal certainty of the investment.