Employee Stock Option Plans (ESOPs) are now a standard part of startup compensation in India — from pre-seed companies competing for early engineers to growth-stage businesses preparing for a public listing. But despite their prevalence, ESOPs are frequently structured incorrectly.
The legal framework is specific. ESOPs in Indian private limited companies are governed by Section 62(1)(b) of the Companies Act, 2013, and Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014. Listed companies are additionally governed by SEBI’s share-based employee benefit regulations.
This article examines six of the most common structuring mistakes Indian startups make with ESOPs, and covers the significant SEBI amendment from June 2025 that changed the rules for founders approaching an IPO.
Note: This article provides general information about ESOP law in India. Specific ESOP design, taxation implications, and regulatory compliance should be assessed with qualified legal and financial advisors.
How ESOPs Work: A Brief Recap
An ESOP gives an employee the right — but not the obligation — to buy shares in the company at a pre-determined price (the exercise price) after a specified waiting period (the vesting period). The key milestones are:
- Grant Date: The date on which options are formally offered to the employee.
- Vesting Period: The period over which the employee earns the right to exercise the options. The most common structure in Indian startups is a 4-year vesting schedule with a 1-year cliff.
- Cliff Period: A minimum period — usually 1 year — before any options vest. If the employee leaves before the cliff, they receive nothing.
- Exercise Price: The price the employee pays to convert options into shares. This is typically set at face value or at fair market value, depending on the stage of the company.
- Exercise Window: The period during which the employee can exercise vested options. The window for departing employees is typically 30–90 days post-exit, as set in the ESOP policy.
Under Rule 12(6) of the Companies (Share Capital and Debentures) Rules, 2014, no vesting of ESOPs can occur earlier than one year from the date of grant, even if the employee leaves. This is a hard legal minimum.
Mistake 1: Not Getting Articles of Association (AOA) Right Before Granting Options
Before a company can grant ESOPs, its Articles of Association must contain a specific provision permitting the issuance of shares under an employee stock option scheme. Many early-stage founders assume the standard AOA templates used during incorporation cover this. They often do not.
If the AOA does not contain the relevant clause, it must be amended through a special resolution of shareholders before any ESOP scheme can be formally adopted. Discovering this gap after grants have already been promised — or after an investor term sheet has been signed — creates immediate compliance problems.
Mistake 2: Skipping the Shareholder Resolution Requirement
Under Section 62(1)(b) of the Companies Act, 2013, an ESOP scheme must be approved by shareholders by passing a special resolution — meaning at least 75% of voting shareholders must approve it. This is a statutory requirement, not a formality.
Some early-stage founders, particularly those who hold 100% of shares initially, treat this step as administrative. When new investors come in, and the cap table diversifies, an undocumented ESOP scheme — or one approved only by board resolution — creates a material compliance gap that surfaces during due diligence.
Mistake 3: Sizing the ESOP Pool Incorrectly
Creating too small an ESOP pool early means repeated shareholder dilution events as the pool is topped up before each funding round. Creating too large a pool too early dilutes founders unnecessarily before the options are needed.
Investors at Series A and beyond typically expect an ESOP pool of 10–15% of the company’s fully diluted capitalisation to be in place — and will often require this as a pre-money condition before completing an investment. The pool is usually created before a funding round closes (which means it dilutes founders, not investors, in the pre-money calculation).
The appropriate pool size depends on the company’s hiring plan over the next 12–18 months. Modelling this against the cap table before each round — rather than reacting to investor demands — gives founders more control over their dilution.
Mistake 4: Setting the Wrong Exercise Price
For early-stage startups, it is common practice to set the exercise price at face value — Rs. 10 or Rs. 1 per share — making options highly valuable if the company grows. However, as a company raises capital and a registered valuer assigns a Fair Market Value (FMV), the exercise price for new grants must be set in a commercially defensible way.
Under Rule 12(3) of the Companies (Share Capital and Debentures) Rules, 2014, the exercise price is determined by the company’s Board of Directors. At the growth stage, SEBI-registered valuers are typically engaged to set the FMV — similar to a 409A valuation in the US context.
Setting the exercise price significantly below FMV for late-stage grants without proper valuation support creates tax risk for employees and potential scrutiny during an IPO.
Mistake 5: Not Accounting for ESOP Taxation at Two Stages
ESOPs in India are taxed twice — a fact that many employees (and some founders) do not fully understand until it is too late to plan around it.
The first tax event occurs at exercise: the difference between the FMV of shares on the date of exercise and the exercise price paid by the employee is treated as a perquisite under the Income Tax Act, 1961, and taxed as salary income at the employee’s applicable slab rate. The employer is required to deduct TDS on this amount.
The second tax event occurs at sale: when the employee subsequently sells the shares, the difference between the sale price and the FMV on the date of exercise is taxed as capital gains — short-term or long-term, depending on the holding period.
For DPIIT-recognised startups, there is a deferral mechanism under the Income Tax Act that allows eligible startups to defer the perquisite tax at exercise until the earlier of: sale of the shares, or five years from the date of exercise, or the date on which the employee ceases to be employed. This deferral is a meaningful benefit for employees of DPIIT-recognised startups and should be communicated clearly in the ESOP policy.
Mistake 6: No Clear Good Leaver / Bad Leaver Policy
What happens to an employee’s vested and unvested options when they leave is one of the most commonly disputed areas in early-stage startup employment. Indian startups frequently either: (a) say nothing about this in their ESOP scheme, leaving it to negotiation each time, or (b) copy a template that does not reflect how the company actually wants to handle departures.
A well-structured ESOP policy distinguishes between:
- Good leaver (resignation for health, family, or other agreed reasons): May retain vested options, typically with a limited exercise window.
- Bad leaver (resignation in breach, cause-related termination): Unvested options lapse; vested options may also be forfeited depending on the terms.
- Death or permanent disability: Typically treated as a special good leaver category with options transferable to legal heirs.
These terms must be set out explicitly in the Board-approved ESOP scheme. Leaving them to an implied understanding creates disputes that are expensive to resolve.
The SEBI June 2025 Amendment: A Change for IPO-Bound Founders
In June 2025, SEBI approved a significant amendment to its share-based employee benefit regulations, formally notified in September 2025. The amendment addressed a specific and long-standing inequity for startup founders.
Under the previous framework, founders who received ESOPs as employees in the early days of the company — before they became classified as promoters — were required to forfeit those ESOPs when the company filed its Draft Red Herring Prospectus (DRHP) for an IPO. SEBI classified founders as promoters at the IPO stage, and existing regulations prohibited promoters from receiving ESOP benefits.
The June 2025 amendment changed this. Founders who held ESOPs granted at least one year before the date of filing the DRHP are now permitted to retain and exercise those options post-IPO. The conditions are:
- The ESOP must have been granted at least one year prior to the date the company filed its DRHP.
- The ESOP must have been granted before the company began the formal IPO process and the drafting of offer documents.
This amendment aligns India’s framework more closely with global practice — where equity-based compensation for founders is recognised as legitimate pre-listing compensation — and removes a structural disincentive that had previously caused founders to restructure their equity arrangements before IPO filing.
Final Thoughts
ESOPs are one of the most powerful tools available to Indian startups — but they only work as intended when they are structured correctly from the outset. The legal requirements under the Companies Act, 2013, and the Income Tax Act, 1961, are specific, and the consequences of getting them wrong tend to surface at the worst possible moment: during a funding round, a secondary sale, or an IPO.
Understanding the framework — shareholder approvals, valuation discipline, tax implications, and a clear leaver policy — is the foundation of an ESOP scheme that serves both the company and the employees it is meant to benefit.¯
