Fully Diluted is Fully Delusional
When is 1% ownership on a fully diluted basis of a $100M company worth $0? More often than you would think.
Most executives focus on the “Fully Diluted” cap table as a shortcut to estimate their share of the future liquidity waterfall. That is delusional. Why? Because the Fully Diluted calculation only measures the theoretical outcome if all security holders are treated equally in the future waterfall and none of the legal provisions in the investment documents are applied. Well, the attorneys draft these documents with the intent of shifting the waterfall, almost always in favor of the investors. This is not inherently unfair as invested capital desires to get its money and expected return paid before the management and founders.
Why does this happen? When a financing is negotiated, management is typically measuring the impact by how dilutive the capital is on a fully diluted basis, thinking that a higher valuation will have less dilution so giving up some legal provisions is a good trade off. In other words, keeping the investor’s percentage lower is better. While that is generally a good idea, it is essential to apply the legal provisions being provided to see what impact they will actually have in the future.
If this is so obvious, then why doesn’t management do these calculations? Because it is very complicated and requires deep legal and financial modeling expertise to actually build a liquidation waterfall. All the investment documents must be organized, the key provisions impacting the waterfall extracted and then converted into formula in a robust Excel model as depicted below to accurately forecast the impact.
What provisions typically impact management and founders share of the liquidation waterfall? There are several provisions in convertible notes, preferred stock, warrants and options that all interact with each other to determine each securityholder’s share. Here are a few significant ones:
Convertible Notes. As fully diluted excludes convertible debt from the percentage, when the convertible notes are converted there can be substantial dilution not apparent from the typical fully diluted cap table. The formula can also have a significant impact as shown in this diagram which our client called the “middle finger deal” because of how much more the Series B noteholder received vs the Series A because of a minor change in the formula.
Preferred Stock. There are several mechanisms to protect preferred holders. The most significant is the preference payment which can enable an investor to get a multiple of their investment from taking money “off the top” and then converting to common. Anti-dilution adjustments can increase the number of shares issued to preferred holders when they convert to common to shift the impact of a dilutive financing to common vs the preferred.
Options. Vesting and exercise price are key determinates, with unvested and out of the money options not participating in the waterfall. Also “Net Exercise” provisions that cancel a portion of the holder’s options to pay the exercise price for the options can also substantially reduce the option holder’s share. Here is an excerpt from a report showing the impact of vesting occurring between two liquidity dates on the amount of distribution to option holders.
How would Capital Waterfall help? Capital Waterfall has developed the most accurate solution for real time, strategic decision making during a company’s entire capital lifecycle. Our solution applies the actual legal provisions contained in both historical and any planned investments to produce accurate deal reports for multiple deal scenarios. Founders and Management can instantly generate side by side reports showing the impact of different deal terms and liquidity assumptions. These reports can be sliced by security class, groups or even individual securityholder. Our clients gain a competitive advantage of accurately forecasting the actual distribution waterfall to know their share, rather than relying on fully diluted only to be disappointed how their expected share has been reduced by the complex formula buried in legalese.