Fully diluted shares are a measure of the total outstanding shares of a company. They include (1) all ordinary shares issued by a company, and (2) all ordinary shares that can be received by converting a convertible security. To calculate the fully diluted shares, we add the total ordinary shares issued and the total converted ordinary shares. Examples of convertible securities include: preference shares, convertible bonds, options such as those granted to employees, and shares reserved for future awards or for future issuing.
Using Fully Diluted Shares
Ownership
A shareholder may determine the fully diluted shares in order to calculate their exact ownership of the company. It is more meaningful to calculate the ownership by taking into account the whole pool of shares and interests. For instance, a shareholder appears to have a 10% interest because they own 100 shares in a company with 1000 ordinary shares outstanding. However, the company has also issued preference shares and employee options and warrants. It is necessary to convert these securities into ordinary shares. Fully diluted shares requires ‘fully diluting’ all convertible securities. This means converting all possible convertible securities into ordinary shares. Assume that the convertible securities lead to an extra 1000 ordinary shares. The fully diluted shares of the company are, thus, equal to 2000 ordinary shares. As a result, the shareholder only has an interest of 5%.
Earnings Per Share
It is necessary to determine the fully diluted shares of a company to calculate the diluted ‘earnings per share’ (EPS). The EPS of a company is an important financial ratio that assists investors in measuring the profitability of the company. Public companies must provide information about the diluted EPS. In Australia, the Australian Accounting Standards Board’s AASB 133 sets the requirements for EPS calculation. A diluted EPS can be calculated by dividing the net income (minus preferred dividends) with the fully diluted shares. The diluted EPS will be lower than a basic EPS which does not consider convertible securities. However, shareholders and investors prefer to calculate a diluted EPS as it reveals the worst possible situation for the shares of a company.
Convertible Securities
A convertible security allows the holder to convert their interest into ordinary shares in a company. Companies seeking to raise capital regularly grant convertible securities like preference shares. Alternatively, a company may issue an option that can be converted into ordinary shares in order to retain a high performing employee without increasing their salary. A company might issue bonds that can be converted into shares in order to reduce the burden of a debt for the company.
A convertible note is another form of a convertible securities. An investor in a startup might use a convertible note. Under a convertible note, an investor grants a loan that turns into interest in the company at a later date in time. For more information on convertible notes, please refer to our guide ‘What is a Convertible Note‘. A new form of a convertible security is a SAFE (‘Simple Agreement for Future Equity’) note. SAFE loans are popular with venture capitalist and other investors investing in start ups. A SAFE note grants an investor the right to receive shares for their investment at a later date or to receive their investment back. For more information on SAFE note, you can refer to our guide ‘Introducing SAFE notes: The revolutionary startup funding process‘.
However, companies should be careful in issuing convertible securities. As the above example shows, convertible securities can significantly decrease a shareholder’s interest. Further, a low diluted EPS will affect the valuation of a company as it means a smaller profit for the shareholder. This ultimately affects the share price.
Conclusion
Fully diluted shares is an important measurement for an investor. They refer to the total outstanding shares of a company. To calculate the fully diluted shares, we add the total ordinary shares issued with the total converted ordinary shares. Fully diluted shares are necessary for calculating the EPS of a company. Companies should be careful about how many convertible securities they grant. This is because too many convertible securities can lower the diluted EPS of a company which may deter investment.
