We are often asked how you count the number of shares or warrants a person should receive when they have been promised a certain percentage of the company. If the company has 2.5 million shares and someone has been promised “one per cent of the company” – what does that mean?
First we should conclude that you cannot create an agreement that a person should receive options corresponding to a certain percentage (unless we count options with dilution protection, which are theoretically possible, but which we advice against). You have to specify a specific number, for example 25,000. This will of course correspond to a certain percentage of the company, but what that percentage is will vary over time, since the number of shares can change. Most often, the company will get more shares, through share issues or because options and warrants are redeemed for shares. If that happens, the 25,000 shares will correspond to a lower percentage. Thus, a percentage is just an on-the-spot account of the ownership.
Getting back to the original question: if a personal is to receive options corresponding to one per cent of the company, what number of options should they receive then (if we assume that one option corresponds to one share)? The simple answer is 25,000, since 1% of 2.5 million is 25,000. But when the employee redeems their options into shares, the company will have at least 2,525,000 shares, and then the 25,000 shares will not correspond to 1%, but rather to (25,000)/(2,500,000+25,000)=0.99% That is fairly close, but if the company has ten employees with the same allocation, then the 25,000 options will only correspond to 0.90%, since there are new 250,000 new shares and (25,000)/(2,500,000 + 25,000)=0.90%.
But would it not be possible to count all these new shares, so that the ownership percentage actually becomes 1% after all options have been converted into shares? When you talk about what the ownership will look like in the future, you often talk about it “on a fully diluted basis”, that is, when all outstanding options have been converted into shares. And if we count this way, and our fictional employee gets 27,526 options and all other employees still get a total of 225,000 options, then we will have a total of 2,752,526 shares in the company (2,500,000+27,526+225,000) when all options have been converted into shares, and then the employee will have exactly 1% of the company.
But we cannot be sure that this is how things end up. In this example we have only counted new shares that come from options. But quite possibly there will be new share issues, some employees may quit before they vest all their options and more employees that were not not planned for from the start may be hired.
Therefore it is probably that the employee in our example will in fact not end up with exactly 1 per cent of the company. Therefore our advice is not to say “you will get one per cent of the company” to instead say “will receive 25,000 options, which currently corresponds to one per cent of the company”. Then you are both clear and unambiguous.