What are fully diluted shares? How do I calculate share dilution?

Every founder and shareholder of a company is scared of having their ownership and shares diluted. But share dilution is inevitable, especially if a company is hoping to grow and take up outside funding. Share dilution takes place when new shareholders are added to the company and new shares are issued to them. And this normally happens when the company gives out employee equity benefits or shares in exchange for funding for the company. But fully diluted shares are not the same as the diluted shares.

Fully Diluted Shares

Fully diluted shares are the total number of common shares of a company that would be outstanding and available to trade in the open market, once all the possible sources of conversion including employee stock options and convertible bonds are exercised. Fully diluted shares include not only those which are currently issued, but also those that could be claimed through conversion.

This number is very important as it is needed for a company’s earning per share (EPS) calculations. And this is because using the value of fully diluted shares increases the share-basis in the calculation while reducing the dollars earned per share of the common stock.

Understanding it better

As mentioned above, the fully diluted shares affect the EPS of the company, which is a common metric for assessing profitability and relative value. EPS represents the total income of the company minus the preferred dividends, divided by the weighted average of common shares outstanding. In this, the weighted average of the common outstanding shares = (beginning period balance + ending period balance) / 2.

If a company can get the earnings per common share to increase, it is considered to be more valuable and the publicly traded share price may increase. Nonetheless, the number of the outstanding shares affect this metric and when the number increases, it reduces the EPS.

How do fully diluted shares work?

Let us assume that there is a company named Services Inc., that earns $10 million in net income and pays preferred shareholders a total of $3 million in dividends. The total income available to the common shareholders is $7 million. If the company’s weighted average of common outstanding shares is a total of 1 million, the EPS would be $7 per share or ($7 million / 1 million shares). This $7 EPS is referred to as “basic” EPS because the total is not adjusted for share dilution.

Example of Fully Diluted Shares

Let us take an example to understand this better. There are several kinds of securities that can be converted into common stock, including convertible bonds, rights, warrants, employee stock options, and convertible preferred stock. Now, let us assume that the company issues about 100k shares in stock options to the employees to reward them for their work in the company.

And the company also has convertible bonds outstanding that allow bondholders to convert their securities into a total of 200k shares of common stock. The company also has convertible preferred stock outstanding and those shares can be converted into 200k shares of common stock as well.

When talking about full dilution, we assume that all 500k additional common shares are issued, which increase the total outstanding common shares to 1.5 million. Applying the $7 million in earnings to common shareholders, fully diluted EPS will be ($7 million / 1.5 million shares) or $4.66 per share, which is lower than the basic EPS of $7.00 per share.

Basic Shares vs. Fully Diluted Shares

Basic shares vs fully diluted shares are two methods that were imposed by the financial accounting standard board in 1997. It is for companies to report their per-share earnings following a standard rule. This is vital as the per share earnings are the center of all financial calculations and decisions. These are the shares that show the investors their portion of the profits in the company. Basic shares vs fully diluted shares are how the amount of shares investors hold in a company are measured.

Basic shares are the number of common shares that are outstanding today, or on the reporting date. On the other hand, fully diluted shares are the total number of shares if the convertible securities of the company were exercised. These securities include convertible bonds, stock warrants, stock options and others.

Diluted shares are the ones that are used to calculate the MVE (market value of equity) of the company, as the market values company shares using diluted stocks. The total number of diluted shares can cause discrepancies in important figures including the company’s EPS or earnings per share; and the diluted EPS can affect the basic EPS. In short, basic shares vs fully diluted shares are not the same.

How to calculate fully diluted shares?

To calculate the fully diluted shares of a company, analysts need to take in consideration all the possible shares that could be held by investors. Here are the steps to calculate the fully diluted shares:

Step 1: Start with the Stock Options

Figure out the number of stock options granted to employees and other shareholders in the company. Since employee stock options can only be exercised if the person is with the company and meets specific requirements, options granted to those who are no longer with the company or have lost the right to the options have to be subtracted from the total.

If other shareholders like outside investors were given stock options, these have to be added to the total number. Each option granted will let us know how many shares the option holder can buy using options, by adding up the total number of shares that all outstanding and valid options grant rights to.

Step 2: Take the Warrants as next

Next, we need to look into the warrants and multiply this figure by the number of shares each warrant can be converted into. Warrants are similar to employee stock options, but they are sold for cash, as opposed to being granted to employees as a form of compensation.

Step 3: Pick up the Convertible Bonds

Find the number of convertible bonds issued by the company and not yet exercised or expired. Convertible bonds are a special kind of financial instrument. They pay a periodical interest just like the conventional bonds, but also can be exchanged for shares. Check out the number of bonds issued, even if outstanding. Note their conversion ratios and expiration dates as well. The conversion ratio is the number of shares the investor will obtain by surrendering the bonds. Multiply the number of unexpired convertible bonds by the conversion ratio.

Step 4: Calculate Fully Diluted Shares

Once you have all the figures, add them. The number that you get would be the additional shares that would be there if the maximum possible dilution takes place. Now, add this figure to the current number of outstanding shares to arrive at the fully diluted share count.

Let us take an example to show this better:

Here, we will calculate the diluted shares outstanding for a company, along with the basic and diluted EPS. In the table below, you will see that the basic shares have been increased by the effect of the employee shares, warrants and options that have been issued.

With the company’s earnings of $1.2 billion, its basic EPS would be $2.40 and its diluted EPS would be $2.35.

Fully Diluted Shares on Eqvista

Eqvista is an application that helps not only in recording all the shares in your company but also in viewing how many fully diluted shares there are. It would help you see how much ownership each shareholder has in the company and what kind of shares they own. With this, you will be able to make smarter company financial decisions.

Here is how the cap table would look like in Eqvista:

Conclusion

Now that you know all about fully diluted shares and how they work, it is time to begin taking your company shares seriously. Eqvista is a cap table application that allows you to record, track and manage all the shares in your company. Everything you do on the application is recording in real time. You will also be able to see all the outstanding shares and by using our tools like round modeling, you will also be able to see how share dilution affects the cap table. Check out the application here or contact us to know more!