What Is a Cap Grant & How It Works for Startups

A “Cap Grant” is not a formally defined or widely recognized term for a specific type of equity compensation in the same way that stock options or Restricted Stock Units (RSUs) are. In the context of early-stage companies and startups, the term “cap” most commonly refers to a “valuation cap,” a concept found in convertible funding instruments like Simple Agreements for Future Equity (SAFEs) or convertible notes. This article explores how equity is granted in startups, often influenced by valuation, and provides an understanding of common equity types and their tax implications.

Understanding Cap Grants

The concept of a “valuation cap” is central to how equity is distributed and valued in startup environments. A valuation cap is a mechanism used in early-stage investments, such as convertible notes or SAFEs, to set a maximum valuation at which an investor’s initial capital will convert into equity. This provision protects early investors by ensuring they receive a predetermined minimum percentage of ownership when the convertible instrument converts into shares, typically during a future equity financing round. For example, if an investor puts $100,000 into a startup with a $5 million valuation cap, their investment will convert as if the company’s valuation was $5 million, even if the actual valuation in a subsequent funding round is much higher, such as $10 million. This allows early investors to obtain a larger ownership stake at a more favorable share price, rewarding them for the higher risk taken in the company’s initial stages.

For convertible instruments with a valuation cap, the conversion to equity happens at the lower of the cap or the actual valuation in a qualified financing event. This contrasts with traditional equity rounds where shares are issued at a fixed valuation from the outset. Using convertible instruments with valuation caps can attract necessary early-stage capital without immediately setting a definitive company valuation.

Key Features of Cap Grants

Equity grants in startups typically come with specific features designed to align recipient incentives with company growth. Vesting schedules are a standard characteristic, determining when and how recipients earn full ownership of their granted equity. Common vesting models include time-based schedules, such as a four-year period with a one-year “cliff,” meaning no equity vests until after the first year, after which it vests incrementally. Alternatively, milestone-based vesting ties the release of equity to the achievement of specific business goals or performance targets.

The value realized from these grants is directly linked to the company’s appreciation over time. If a company’s valuation increases significantly from the initial grant price, the equity held by the recipient becomes more valuable. Unlike stock options, direct equity grants like RSUs do not usually have an “exercise” component; instead, they convert directly into shares upon meeting vesting conditions.

Cap Grants Versus Other Equity

When considering equity compensation, startups primarily utilize stock options and Restricted Stock Units (RSUs). Stock options grant the recipient the right, but not the obligation, to purchase company shares at a predetermined price, known as the exercise or strike price. This price is typically set at the fair market value at the time of grant, offering potential upside if the company’s value increases. Stock options are common in early-stage startups due to their potential for substantial gains if the company thrives.

Restricted Stock Units (RSUs), conversely, represent a promise to deliver actual company shares to the recipient once specific conditions, usually vesting, are met. Unlike stock options, RSUs do not require the recipient to purchase the shares; they are granted at no cost. RSUs tend to offer more predictable value because they always have worth as long as the company’s stock has value, unlike options which can become worthless if the stock price falls below the exercise price. RSUs are often favored by more mature startups or established companies due to their stability and simpler administration.

Tax Treatment of Cap Grants

The tax implications for recipients of equity grants in startups depend on the specific type of equity received. If the grant refers to direct company shares, such as Restricted Stock Units (RSUs), taxation generally occurs at the time of vesting. At this point, the fair market value of vested shares is typically taxed as ordinary income, subject to federal and state income taxes, and potentially Social Security and Medicare taxes. Employers often withhold a portion of the vested RSUs to cover these tax obligations.

For equity granted through stock options, the tax event is usually deferred until the options are exercised, and sometimes again upon the sale of the shares. Non-qualified stock options (NQSOs) are taxed as ordinary income on the difference between the fair market value and the exercise price when they are exercised. Incentive Stock Options (ISOs) receive more favorable tax treatment, potentially qualifying for capital gains rates upon sale if certain holding period requirements are met. Any subsequent profit from selling vested shares, whether from RSUs or exercised stock options, may be subject to capital gains tax, classified as short-term if held for one year or less (taxed at ordinary income rates) or long-term if held for more than one year (taxed at lower preferential rates).