By: Robert Hawn

As a business lawyer in the Silicon Valley area of California, I find that one of the most important issues founders of a high tech start-up company have to consider is its ownership, or capital structure. As you grow your company, it is important to understand your percentage ownership of the company. The different types of equity incentives and funding instruments will have varying impacts to your ownership, and you need to keep this in mind as you grant options to your employees and accept funding from your investors.

In the last blog in this series , I discussed some of the basic concepts of determining the number of shares of outstanding stock, and the number of shares of fully diluted stock, to help explain how investors look at ownership in a company. To summarize, the number of shares of outstanding stock equals the number that are issued and held by a shareholder. The number of fully diluted shares, however, are the number of outstanding shares, PLUS the number of shares that can be issued on exercise of contracts that enable the holder to purchase shares, such as stock options and warrants.

When you are dealing with the typical family business, or owner operated business, outstanding shares and options are about as deep as you need to get. When you are dealing with a typical high tech start-up which has gone through a couple of rounds of financing, the situation can get a bit more complicated.

Let’s first look at how a commonly used angel funding vehicle can affect the process of determining the number of fully diluted shares. In very early stage companies, where there is not even a product, much less revenues or profits, it is almost impossible to determine the value of the company. As a result, angel investors often provide funds through a “convertible note”. In a convertible note, a company borrows money from an investor and provides a note, essentially a promise to repay. The note, however, can convert into shares that are issued in the next round of funding. The rate at which the note converts is based on the value of the shares in the next round. Essentially, the investors forgive their debt under the note in exchange for shares. The idea here is that once the company has some history, it will attract venture investors who know how to value early stage companies. By converting into shares issued in a round led by venture capitalists, the angel investors will piggyback on the valuation determined by the venture investors. To compensate the angels for investing early on, they often receive a discount on the purchase price set in the venture round (although the venture investors may try to limit this).

Using convertible notes creates some difficult issues in calculating the number of fully diluted shares. First, you don’t know how many shares will be issued on the conversion of the notes. This is because the rate at which the notes will be converted into stock is based on the per share price in the next round of financing. The share price, in turn, is based on the value of the Company. Because the venture investors have yet to determine valuation, you don’t know what the purchase price of the next round is. As a result, you don’t know the conversion rate of the note or, correspondingly, the number of shares that will be issued once the note converts.

Second, founders often cannot be convinced that the interest payments under the note should not convert. If interest converts, the number of shares issuable under the note changes daily as interest accrues. This results in the number of shares allocated to the notes to increase slightly each day, and the percentage of shares held by other stockholders, such as the founders, to decrease each day.

Let’s fast forward. You’ve now grown your company and created enough value and buzz to close a serious investment round, and all of your convertible notes have gone away. You now have investors who have purchased stock from your company. The stock they have purchased, known as convertible preferred stock , however, is a little different from the common stock you likely hold. One major difference is that convertible preferred stock can convert into the same kind of common stock you hold. This is convenient, because it allows you to determine the number of fully diluted shares by applying the conversion rate of the preferred stock against the number of outstanding shares of preferred stock, and generate the number of common stock equivalent shares. If you have an option plan, you can assume all of the options are converted into common stock. Once everything is reduced to common stock, you can count up the number of shares and that is your number of fully diluted shares. Pretty easy, huh?

At this stage, yes, but let’s fast forward even more. Because of some misfortunes, you had to take in investment funds as part of a “down round” (so named because the price of the preferred stock was down from the previous round). One common feature of convertible preferred stock in a start-up context is a device that protects the investor if there is a later down round. The device, often referred to as price-based antidilution, will change the conversion rate of the preferred stock issued in the earlier round. The change will, as you might guess, result in relatively more common stock being issued for each share of preferred. So, if there has been a down round, you need to account for the impact of this antidilution feature in determining the number of fully diluted shares. You can imagine this can get pretty complicated if your company has already done a number of investment rounds, each with different purchase prices, some of which may have an antidilution provision triggered in connection with a particular subsequent round, and some of which may not.

The information appearing in this blog does not constitute legal advice or opinion. Such advice and opinions are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to Strategy Law, LLP.