ESOPs in India: what founders get wrong
Almost every startup we work with has an ESOP. Far fewer have one that would survive scrutiny, because the approval, the written scheme or the grant letters were never actually done.
Summary
- An ESOP exists only if shareholders approved it, a written scheme sets out the terms, and each employee holds a signed grant letter. Missing any of the three, you have a promise rather than an option.
- Count the whole approved pool in your fully diluted cap table, and model any pre-money top-up before you agree to it, because that dilution falls entirely on the founders.
- Employees are taxed at exercise on a gain they cannot yet sell. Explain it at grant, and check whether your company qualifies for the eligible-startup deferral.
Almost every startup we work with has an . Far fewer have one that would survive scrutiny.
The usual pattern: a pool appears in the , offer letters mention options, a spreadsheet tracks grants. But the shareholder approval was never passed, there is no written scheme, and the grant letters do not say what happens when someone leaves. On paper, nothing exists.
That is survivable until the moment it isn't: a diligence, an acquisition, or an employee who wants to exercise and discovers there is nothing to exercise.
Step one: your pool has to be legally created
An option pool isn't a decision you make. It's an approval you obtain.
Section 62(1)(b) of the Companies Act, 2013 lets a company issue shares to employees under a stock option scheme. For an unlisted company the detail sits in Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014, which requires a special resolution of shareholders: at least three votes in favour for every one against. A 2015 exemption allows a private company to use an ordinary resolution under the section itself, but the rule was never updated to match, so the safe course, and the one most practitioners follow, is a special resolution.
Along with it you need a written scheme setting out who is eligible, the pool size, vesting, exercise price and exercise period.
Without those two things, what you have is a promise, not an option.
A quick self-test. Can you produce (a) the shareholder resolution approving the pool, (b) a written ESOP scheme, and (c) a signed grant letter for each employee? If any of the three is missing, fix it before your next round, not during it.
The good news: this is almost always repairable. It is just cheaper and quieter to repair now.
Step two: sizing the pool, and who pays for it
Most Indian startups we see run a pool of around 5 to 15% of fully diluted , growing through the early rounds and then stabilising.
Two things founders get wrong here.
Counting only granted options. Your fully diluted number must include the whole approved pool, granted or not. Leaving out the ungranted portion makes your cap table look better than it is, until an investor recalculates it.
Agreeing to a pre-money top-up without doing the maths. Investors typically ask you to top the pool up as part of a round. If the top-up happens , the comes entirely out of existing shareholders, the founders. If post-money, the new investor shares it. This is the pool shuffle at your next round, and it is often worth more than a few points of valuation.
Before you agree to a number, work out who actually pays for a top-up on your own cap table.
Step three: vesting, and the words that matter
Standard in India is four years with a one-year cliff. Nothing vests in year one; at the twelve-month mark 25% vests at once; the rest vests monthly or quarterly. The cliff is also a legal floor: Rule 12 requires at least one year between grant and vesting.
The parts founders skip:
- Acceleration. What happens to unvested options if the company is acquired? Single trigger means they vest on the acquisition. Double trigger means they vest only if the acquisition happens and the employee is let go. If your scheme says nothing, the acquirer inherits a retention problem and it becomes a live issue in the deal.
- Exercise window after leaving. If you say nothing, you will end up deciding it emotionally in the middle of a resignation. Write it down now.
- Good leaver and bad leaver. Define what forfeits vested options, usually termination for cause or breach, and keep the definition narrow enough that it is not a threat.
Step four: the tax moment nobody warns employees about
This is the part that quietly wrecks ESOPs in practice. Tax hits twice.
At exercise. The difference between the fair market value of the share on the exercise date and what the employee pays is treated as salary income, as a perquisite, and taxed at their slab rate. This is tax on a paper gain: no shares have been sold, no money has come in. The employer deducts tax at source, so it typically comes out of their salary.
At sale. Whatever they gain above that fair market value is taxed as capital gains when they eventually sell.
So an employee in the 30% slab, exercising options on shares worth ₹10 lakh more than they paid, faces a bill of roughly ₹3 lakh, before cess, in cash, for something they cannot sell.
Two consequences. Employees let options lapse because they cannot fund the exercise. And founders discover at an acquisition that half the team never exercised, so the retention they thought they had built did not exist.
The eligible-startup deferral
There is a deferral that lets employees postpone the exercise-stage tax, but only at an eligible startup. alone is not enough: the company also needs the Inter-Ministerial Board certificate under the startup tax-holiday provision, of the 1961 Act, which the Income-tax Act, 2025 carries forward. Few recognised startups hold that certificate.
Where it applies, the tax falls due at the earliest of three points: the end of a fixed period after the year of allotment, the sale of the shares, or the employee leaving. Under the 1961 Act that period was 48 months from the end of the assessment year of allotment. The new Act took effect in April 2026, so confirm the period that applies to your allotment date before you tell your team.
Whatever your situation: explain the tax at grant, not at exercise. A one-page explainer with the grant letter prevents most of this.
Step five: liquidity, or the option nobody can cash
An option with no route to money isn't compensation. It is a story.
In a private company, the realistic paths are a during a funding round, a company-run buyback, or an exit. Decide early which of these you intend to offer and say so honestly. "We'll look at liquidity around " is a fair answer. Silence is not.
If you do run a buyback, it needs a process, a defensible pricing basis, and the right approvals, not an ad hoc transfer arranged over chat.
Who can and can't hold options
Eligibility is narrower than most founders assume. Broadly, ESOPs are for employees and directors of the company, its holding company or its subsidiary. Independent directors are excluded.
Two groups get missed:
- Promoters and the promoter group, along with any director who holds more than 10% of the equity, are excluded. A DPIIT-recognised startup is exempt from that exclusion for ten years from incorporation. Check the current wording before granting to a co-founder who is a promoter.
- Advisors and consultants who are not employees cannot hold ESOPs. If you want to give them equity, it has to be structured differently, and calling it an ESOP anyway is exactly the kind of thing a diligence team finds.
What to fix this quarter
- Locate your shareholder resolution, written scheme and signed grant letters. If any are missing, start there.
- Maintain an option register: grant date, number, exercise price, vesting schedule, status.
- Reconcile that register against your cap table and against what is in offer letters.
- Add acceleration, exercise window and leaver terms to the scheme if they are absent.
- Send every option holder a one-page explainer on how the tax works.
Done properly, an ESOP is one of the few tools a startup has to compete with bigger salaries. Done loosely, it is a liability that shows up when you can least afford it.
Frequently asked questions
Do you need shareholder approval to create an ESOP in India?
Yes. Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014 requires a special resolution for an unlisted company's scheme under section 62(1)(b) of the Companies Act, 2013, along with a written scheme covering eligibility, vesting, exercise price and exercise period. A pool that exists only in a cap table or an offer letter has not been validly created, and it is one of the most common gaps found in diligence.
How are ESOPs taxed in India?
Twice. At exercise, the gap between the share's fair market value and the exercise price is taxed as salary income at the employee's slab rate, with tax deducted at source, even though nothing has been sold. At sale, any further gain is taxed as capital gains. Employees of an eligible startup, one with DPIIT recognition and the Inter-Ministerial Board certificate, can defer the exercise-stage tax.
What is a typical ESOP pool size for an Indian startup?
Most run a pool of roughly 5 to 15% of fully diluted equity, topped up at funding rounds. The right number depends on how many senior hires you need before the next raise. What matters more than the size is whether the whole approved pool, granted and ungranted, is in your fully diluted cap table.
If you want the resolution, scheme, grant letters and option register checked and put right before your next round, our compliance and governance work starts there.
Current as at September 2026, and the tax section in particular: ESOP tax rules have moved more than once, and the Income-tax Act, 2025 took effect in April 2026. General guidance, not legal or tax advice.
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Lead - Company Secretarial, Compliance & Fundraise Advisory
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