What does fully diluted valuation mean?
The pre-money valuation that is used to determine the price of stock given to investors is frequently the major topic of negotiation during fundraising. Pre-money valuation describes the startup's estimated value before any fundraising has taken place. The percentage of the corporation that investors will receive in return for their investment is determined by the pre-money value, which is important.
Typically, startup investors base their ownership calculations on the corporation's fully diluted valuation. In this sense, valuation refers to a company's capital structure or the distribution of its debt and equity. The phrase "diluted" describes how each time new shares are issued, the ownership proportion that each share of stock represents is diluted. Fully-diluted refers to a value that is determined under the assumption that all existing and future obligations to issue shares have been met.
Therefore, a fully diluted valuation means that -
In addition to shares that have already been issued, fully diluted shares also comprise shares that may be acquired through conversion. This number of shares is required to calculate a company's earnings per share (EPS), as employing fully diluted shares raises the calculation's share basis while lowering the amount of money made per share of common stock.
Not all businesses can have a fully diluted valuation
Fully diluted capitalization has no single definition. For instance, a fully-diluted capitalization may not include unissued shares reserved for issuance under a stock plan. Since startups often do not issue equity after being acquired, this is frequently done when determining the fully-diluted capitalization in connection with an acquisition.
If you recently made an investment in a blockchain project, chances are that the asset you bought has a fully diluted valuation that is substantially higher than its current market capitalization. This is typically not a good sign for the long run.
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How it works is that crypto startups can bring in investors to stake in the business and grow the overall supply in circulation. When there are more investors staking in the crypto projects, it will further dilute the valuation that is substantially higher than the current market. This may be a problem during a recessionary period as liquidity in the business will be tight once investors attempt to withdraw their capital.
Simply put, due to investor vesting, ecosystem rewards, and staged airdrops, these projects often only have a small portion of their overall supply in circulation at any given moment. Over time, however, these factors drastically increase their circulating supply.
The importance of a fully diluted valuation
Most startups need to obtain a large sum of money, typically measured in the multiple millions of dollars for even less ambitious investment, in order to create and market a successful product. Businesses typically impose rigorous vesting periods on investors to assist match the two — both obtaining sizable capital and starting with a modest market cap to drive secondary market demand. Without working burn mechanics, this ultimately results in considerable inflation and sell-side pressure.
Rarely, buy-side demand may be sufficient to offset its quickly increasing investment while allowing the firm to continue expanding. But it's not common to see this. Similar to the previous point, it is a popular misunderstanding that companies won't often drop below the lowest price that investors paid during their initial presale stages, such as the angel, seed, or pre-sale rounds.
Conclusion
A fully diluted valuation may be great for investors if they see huge future potential for their business. With more capital raised from the diluted valuation, startups especially can invest more into the business. However, startups will need to understand the broader market as well not to have some level of security in the business.