For a startup, people are one of its most important assets. A business may have a good idea, technology or funding, but its growth also depends upon the people who work towards building it. However, startups often face difficulty in attracting and retaining skilled employees because they may not always be able to offer salaries comparable to larger and more established companies.
This is where Employee Stock Option Plans, commonly known as ESOPs, become useful. Instead of relying entirely on higher salaries or bonuses, startups can offer employees an opportunity to participate in the company’s future growth by giving them a right to acquire shares at a predetermined price, subject to certain conditions.
But ESOPs are not simply about giving employees shares in the company. They involve a legal structure consisting of grants, vesting, exercise, taxation and compliance requirements. For founders, understanding these aspects is important before setting up an ESOP scheme.
What Exactly Is an ESOP?
An Employee Stock Option is essentially a right given to an eligible employee to acquire shares of the company at a predetermined price, known as the exercise price, subject to the terms of the ESOP scheme.
It is important to distinguish an option from an actual share. When an employee receives an ESOP, they do not immediately become a shareholder. They first receive the option to acquire shares in the future, usually after satisfying certain vesting conditions.
For example, suppose a startup grants an employee 5,000 options at an exercise price of ₹20 per share. If the options vest and the employee chooses to exercise them, the employee would pay ₹1,00,000 to acquire the corresponding shares, subject to the terms of the scheme and applicable law.
The potential benefit for the employee arises if the value of the company’s shares increases. If the shares are worth ₹100 per share at the time of exercise, the employee has acquired them at ₹20 per share. The difference may have tax consequences, and the employee may also have further tax consequences when the shares are eventually sold.
Thus, an ESOP can align the interests of employees with the long-term growth of the company. If the company succeeds, the employee may also benefit from the increase in the value of their shares.
It is equally important to remember that an ESOP is not a guaranteed financial benefit. Its eventual value depends on the company’s performance, valuation, dilution, liquidity and the employee’s ability to ultimately sell the shares.
Legal Framework Governing ESOPs in India
For companies incorporated under the Companies Act, 2013, ESOPs are primarily governed by Section 62(1)(b) of the Companies Act, 2013, read with Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014.
Section 62(1)(b) provides the statutory basis for issuing further shares to employees under an employee stock option scheme. Rule 12 sets out various requirements relating to the scheme, including eligibility, shareholder approval, disclosures, vesting and exercise-related matters.
For companies to which the general rule applies, shareholder approval for an ESOP scheme is required by way of a special resolution. However, eligible private companies may benefit from exemptions under applicable MCA notifications, subject to the conditions prescribed for such exemptions. Companies should therefore determine the approval route applicable to their particular circumstances rather than assuming that the same requirements apply to every company.
Rule 12 also contains eligibility restrictions. Broadly, promoters and persons belonging to the promoter group, as well as directors holding more than 10% of the outstanding equity shares directly or indirectly, are excluded from the definition of eligible employees. However, a startup falling within the prescribed definition can benefit from an exemption from these restrictions for a specified period of up to ten years from incorporation or registration, subject to the applicable conditions.
The company is also required to maintain a Register of Employee Stock Options in Form SH-6 and make prescribed disclosures in its Directors’ Report.
For listed companies, ESOPs are additionally governed by the Securities and Exchange Board of India (Share Based Employee Benefits and Sweat Equity) Regulations, 2021, as amended from time to time.
Therefore, while ESOPs may appear to be primarily an HR or compensation tool, their implementation involves corporate law, securities law and tax compliance at several stages.
Vesting and Exercise: When Does the Employee Actually Get the Shares?
An ESOP does not generally become exercisable immediately after it is granted. The employee must first satisfy the vesting conditions specified in the scheme.
Vesting refers to the process by which the employee earns the right to exercise the options. A common structure is a four-year vesting period with a one-year cliff. Under such an arrangement, an employee may receive a grant of 5,000 options but become entitled to exercise only a portion after completing the first year, with the remaining options vesting periodically over the next three years.
For companies governed by Rule 12, there must generally be a minimum period of one year between the grant of options and their vesting, subject to the specific exception provided in the Rules.
After the options vest, the employee may exercise them by paying the exercise price within the exercise period specified under the scheme. Once validly exercised, the corresponding shares are issued or allotted in accordance with the applicable corporate procedures.
What happens if the employee leaves before the options have fully vested?
This is where the terms of the ESOP scheme become particularly important. The treatment of vested and unvested options may differ depending on whether the employee resigns, is terminated, retires, dies or becomes permanently incapacitated. The Rules themselves prescribe certain consequences for some of these situations, while the scheme sets out the applicable exercise conditions.
For example, an employee who resigns after two years may retain certain vested options but lose all unvested options, depending on the terms of the scheme and the applicable exercise window.
Founders should therefore ensure that the consequences of leaving the company are clearly documented from the beginning rather than relying only on a standard vesting schedule.
ESOP Pool and Dilution: What Founders Need to Consider
One of the most important questions for founders is: how many shares should be reserved for the ESOP pool?
An ESOP pool represents the portion of the company’s equity that may ultimately be issued or transferred to employees under the scheme. It is often discussed on a fully diluted basis, meaning the calculation takes into account shares that may arise from outstanding options and other convertible instruments.
For example, assume a startup has 90,000 existing shares and creates an ESOP pool of 10,000 options. On a simplified fully diluted basis, the pool would represent approximately 10% of the company’s equity.
This matters because issuing shares pursuant to ESOPs can dilute the percentage ownership of existing shareholders.
Dilution becomes particularly important during fundraising. Investors may negotiate for an ESOP pool to be created or increased before their investment so that the dilution arising from the pool is borne by the existing shareholders rather than the incoming investor.
The headline percentage of the pool can therefore be misleading. Founders should consider the pool alongside the existing cap table, outstanding options, convertible instruments, anticipated hiring needs and future fundraising plans.
The objective should not simply be to create the largest possible pool, but to create one that is sufficient for the company’s expected needs without causing unnecessary dilution.
Taxation of ESOPs
Taxation is one of the more complicated aspects of ESOPs because there can be tax consequences at more than one stage.
When shares or securities are allotted or transferred to an employee pursuant to the exercise of an option, the benefit represented by the difference between the fair market value of the shares on the relevant date and the amount actually paid by the employee is generally treated as a taxable perquisite under the applicable income-tax provisions.
For example, if the fair market value of the shares is ₹100 per share and the employee exercises the option at ₹20 per share, the difference of ₹80 per share represents the perquisite value. For 1,000 shares, this would result in a perquisite value of ₹80,000, subject to the applicable valuation and tax rules.
This is important because the employee may face a tax liability even though the employee has not yet sold the shares and received cash from them.
ESOP Tax Deferral for Eligible Startups
Eligible startups can benefit from a statutory deferral mechanism in respect of the tax arising on qualifying ESOP perquisites, subject to the conditions prescribed under the applicable income-tax law.
There is an important transition in this area. For tax years governed by the Income-tax Act, 1961, the earlier framework provided for a specified deferral period from the end of the relevant assessment year, along with other triggering events such as sale of the specified securities or cessation of employment.
The Income-tax Act, 2025, which applies from 1 April 2026, contains the corresponding framework under the new tax-law structure. For qualifying cases covered by the new Act, the time-based trigger is 60 months from the end of the relevant tax year. Other specified trigger events, including sale of the securities and cessation of employment, also remain relevant. The applicable tax is required to be deducted or paid within the prescribed period after the earliest applicable trigger.
The benefit is available only where the statutory conditions for an eligible startup and the relevant employee are satisfied. Merely being described as a startup or having startup recognition does not automatically make every ESOP grant eligible for the tax-deferral mechanism.
The deferral is also not an exemption. It postpones the timing of the tax deduction or payment; it does not eliminate the underlying tax liability.
Tax When the Employee Sells the Shares
There may also be capital gains tax consequences when the employee subsequently sells the shares. Broadly, the gain is computed with reference to the sale consideration and the applicable cost of acquisition, with the fair market value taken into account for determining the cost of shares acquired through the ESOP exercise.
For capital gains purposes, the period of holding is generally relevant from the date of allotment or transfer of the shares rather than from the date on which the option was originally granted. The applicable short-term or long-term capital gains rules will depend on the nature of the security and the law applicable at the time of sale.
This makes it important for employees to understand that receiving or exercising an ESOP does not necessarily mean receiving immediately available cash. An employee may have to pay the exercise price and may also have tax obligations even before actually selling the shares.
What Should Founders Consider Before Introducing an ESOP?
An ESOP scheme should not be created merely because it is common among startups. Founders should first consider what they actually want the scheme to achieve.
What is the purpose of the ESOP?
Is it intended primarily to attract senior employees, retain existing employees, reward long-term contribution, or align employees with the company’s growth? The answer should influence who receives options, how much they receive and how the vesting structure is designed.
How large should the ESOP pool be?
A pool that is too small may not serve its purpose, while an unnecessarily large pool can result in greater dilution for existing shareholders. Founders should model the pool against expected hiring plans and future fundraising rather than selecting a percentage simply because it is commonly used in the market.
What should the vesting structure look like?
The company should decide the vesting period, cliff, exercise period and treatment of options when employees leave. The scheme should also address specific events such as death, permanent incapacity, resignation and termination.
What happens during an exit?
Founders should consider how ESOPs will be treated in the event of an acquisition, merger, IPO or other liquidity event. Depending on the transaction and scheme, options may be accelerated, substituted, cancelled, exercised or otherwise dealt with, subject to applicable law and transaction documents.
How will the shares be valued?
Since taxation and employee expectations can depend on valuation, the company should maintain proper valuation and documentation and ensure compliance with the applicable corporate, tax and accounting requirements.
Finally, communication matters. Employees should know how many options they are receiving, the exercise price, vesting schedule, what happens if they leave and what the realistic possibilities of an exit or liquidity event are.
Conclusion
For startups, ESOPs can be an effective way of connecting employee incentives with the long-term growth of the company. They can help startups compete for talent, encourage employees to stay for longer periods and create a sense of participation in the company’s success.
At the same time, ESOPs should not be viewed as a simple promise of future wealth. They are structured legal rights that operate within a framework of corporate approvals, vesting conditions, taxation, valuation, accounting requirements and potential dilution.
For founders, the real challenge is therefore not merely creating an ESOP pool. It is designing a scheme that is legally compliant, commercially sensible and clearly understood by the people receiving it.
A well-designed ESOP can benefit both the startup and its employees. But for that to happen, the scheme needs careful planning from the very beginning.
Disclaimer: This article is intended for general informational purposes only and does not constitute legal, tax, accounting or investment advice. ESOP structures and their tax treatment can vary depending on the company’s constitution, listing status, employee circumstances, applicable exemptions and the law in force at the relevant time. Startups and employees should obtain professional advice before implementing or exercising an ESOP.