When talking to people about option grants, refer to “fully diluted” and always promise a share amount not just a percentage.
I often get asked: “When I tell a new hire how many shares he or she is getting, should I tell them the percentage this represents and, if so, should I express this as a percentage of ‘fully diluted’ or ‘issued and outstanding’?
At the outset, my standard advice is try to avoid expressing option grants only as a percentage in the formal legal documents unless requested by the recipient. It can lead to problems later, usually because the recipient didn’t understand that his or her options would be subject to further dilution as the company issued more shares through option grants, fundraising, etc.
However, recipients of options often do ask for the percentage. It’s a fair question because the relevance of the number of shares being granted is impossible to grasp unless you have more information about the capital structure of the company. Receiving a grant of 1 million shares might sound great in absolute terms, but it’s not as attractive on a relative basis if there are 1 billion shares outstanding (to use an absurd example).
Issued and Outstanding vs. Fully Diluted
First, let me explain the difference between these two terms. “Issued and outstanding” means the number of shares actually issued by the company to shareholders. For example, your company may have “authorized” 10 million shares to be issued, but may have only “issued” 6 million of them, meaning there are another 4 million shares that are authorized to be issued at a later time. Outstanding options are not counted because they only represent a right to purchase shares in the future when they are “exercised.” Until that happens, they are not “issued” shares.
On the other hand, “fully diluted” usually means issued stock (common and preferred stock, as if converted to common stock), issued options (or warrants, which are similar to options) and (usually) options reserved in the stock option pool. In other words, it assumes that the entire option pool has been granted, and that all of those options have been exercised. Investors usually think in terms of fully-diluted capitalization because it better reflects their true ownership position.
Let’s look at some numbers:
Click here to view the table.
Of course, the actual number of options being granted is the same in both cases, so the expression of the percentage is merely optical. For this reason, companies sometimes like to express this as a percentage of issued and outstanding because the percentage will be higher and it will appear to make their offer more attractive. However, I generally advise against this. One of the problems with using issued and outstanding is that as you issue more shares, future grants will need to be higher in order to equal the same percentage.In this example, there are 8 million issued and outstanding shares, and 10 million shares on a fully diluted basis. Therefore, if you are granting 100,000 options to a new hire in New Corp., they would be receiving 1.25% of the outstanding shares (i.e., 100,000/8,000,000), and 1% of the fully diluted shares (i.e., 100,000/10,000,000).
For example, using the numbers above, assume you agree to grant a new hire an option to purchase 1% of the issued and outstanding shares. That would result in an option for 80,000 shares (1% x 8,000,000 shares). Also assume that person exercised his/her options. The new number of outstanding shares is now 8,080,000 after exercise.
If you hire another person and also promise them a 1% stock grant, you now need to grant them 80,800 options (i.e., 1% x 8,080,000 shares). That can be confusing if the two employees compare notes and think they were both promised 1% of the company.
If you include a percentage in an offer letter for an employee, I recommend you use the share amount, and language along the lines of: “Subject to Board approval, you would receive an option covering [X] shares of the Company’s common stock (representing approximately [X]% of the Company’s stock on a fully diluted basis including all shares reserved under the Company’s option plan).”