For example, if TechStartup, Inc. has a pre-money valuation of $4.5 million and 3 million shares of common stock outstanding, the price per share of Series A will be $1.50 (i.e. $4.5 million divided by 3 million shares outstanding). However, in most deals, the total number of shares outstanding is said to be on a fully-diluted basis. Most of the time, this means that the total number of shares will include all outstanding common stock PLUS all outstanding options, warrants and other convertible securities (including any previously issued convertible preferred stock) as if fully exercised or converted into common stock. Therefore, if TechStartup, Inc. had issued options to its employees to purchase an aggregate of 1,500,000 shares of common stock, the total number of shares outstanding on a fully-diluted basis will be 4,500,000 shares. Now, the per share price is only $1.00.
By basing the per share price on the fully-diluted basis, the investors are making the existing common stockholder assume the diluting effect of the unexercised options. Sometimes, investors will also negotiate for the fully-diluted number to include unissued options and any increase in the size of the option pool in connection with the financing. Occasionally, venture capital investors will request that an option pool be increased to make sure there is enough shares to provide adequate incentives to the startup’s employees and management. This will dilute the existing common stockholder even more.