How to read a cap table before you sign

Startup equity looks simple until the company is sold. Dilution, option pools and liquidation preferences decide who actually gets paid, and they are all visible on paper long before anyone is counting millions.

A capitalisation table, or cap table, is the record of who owns what in a company. For a founder raising money or an early employee offered shares, it is the most important document in the building. It is also the one people most often sign without fully understanding.

"In some cases, founders don't fully understand the terms they're signing up for," wrote venture firm Airtree when it published its standard seed-stage term sheet. "This seems crazy to us."

Start with dilution. Every time a startup raises money by issuing new shares, existing owners hold a smaller slice. Take two founders who own the whole company. At the seed round, they sell 20 per cent to investors and set aside 10 per cent of the company for staff options. The founders now own 70 per cent between them. At Series A, the company sells another 20 per cent, and everyone's stake shrinks by a fifth. The founders are down to 56 per cent, or 28 per cent each, after just two rounds. The question is whether each round increased the value of the company by more than it cut the founders' share.

Next is the option pool, the slice reserved for current and future employees. "At Seed and Series A stage, we usually like to see an Employee Option Plan of around 10-15% of the company," Airtree says in its guide to employee option plans. Watch when the pool is created. If investors require it to be set up before their money comes in, the dilution falls entirely on the existing shareholders.

Then come liquidation preferences, which set the order in which money flows when a company is sold. The simplest version is one times, non-participating. Say an investor put in A$10 million for 20 per cent and the company sells for A$30 million. With a one times preference, the investor can take either its A$10 million back or its 20 per cent share, which is A$6 million. It will take the A$10 million, leaving A$20 million for everyone else.

Now make that preference participating. The investor takes its A$10 million first and then 20 per cent of the remaining A$20 million, a total of A$14 million. Multiple preferences, which return two or three times the money invested before anyone else is paid, tilt the outcome further. Airtree lists "multiple liquidation preferences" among the terms it avoids at seed stage, alongside "ratchet provisions" that protect investors if later rounds are priced lower.

Finally, check for SAFEs. Many early rounds now use a Simple Agreement for Future Equity (SAFE), created at Y Combinator in 2013. It is "a short contract an investor signs to fund your startup now in exchange for the right to shares of stock in your startup later," according to Y Combinator. SAFEs convert into shares at the next priced round, often with a valuation cap or a discount, so they need to be added to the cap table on a fully converted basis to see who really owns what.

For an early employee, the questions are simple. How many shares or options are you getting, and out of how many in total on a fully diluted basis? What is the exercise price? What preferences sit ahead of ordinary shares? Without those answers, a percentage means very little.

A cap table is the only honest answer to the question "what is my equity worth?" Founders should model every round forward before signing, and employees should ask for the fully diluted share count and the preference stack before accepting options instead of salary. Vanilla terms, one times non-participating preferences and a clearly sized option pool are signs of a fair deal. Anything more exotic deserves a lawyer's read. None of it matters if the company fails, but when it succeeds, these clauses decide who shares in the win.