Employment contracts and HR compliance for Indian startups
Authored by - Adv. Pranay Sawant, Senior Executive at Outsource360
The diligence request arrives as one line on a spreadsheet: copies of appointment letters for all employees, together with the current employee handbook.
The company has thirty-four people. It also has thirty-four signed offer letters, sent as PDFs from a founder's mailbox, each two pages long, each promising that a detailed appointment letter will follow on confirmation of employment. None ever followed. The handbook is a Notion page last edited nineteen months ago, and the policy it links to on workplace harassment is a copied American template referring to a hotline nobody set up.
Nothing about that was unusual for an Indian startup in 2023. It is a statutory breach in 2026.
Since 21 November 2025, when the four labour codes were brought into force, a written appointment letter has been a legal duty owed to every employee, not a courtesy extended to senior hires. Since 8 May 2026, when the central rules under the codes were notified, the letter has a prescribed format and has to exist before the person starts work. The gap between an offer letter and an appointment letter, which most founders treat as an administrative lag, is now the gap between compliant and not.
Then the buyer's counsel reads the contract itself.
The non-compete runs for two years after exit and covers the whole of India. It is void, and has been void since 1872, because section 27 of the Indian Contract Act voids any agreement that restrains a person from exercising a lawful profession, trade or business. The Delhi High Court said so again on 25 June 2025, holding a three-year restriction in a software engineer's contract unenforceable. The clause is not merely weak. It cannot be enforced at all, which means the retention story the founders told their investors rests on nothing.
There is no intellectual property assignment for the two design contractors who built the product's entire visual identity. Under section 17 of the Copyright Act, 1957 the employer is first owner of what an employee makes in the course of employment. A contractor is not an employee, and the default runs the other way. The contractors own the work.
And there is the engineer in Pune, invoicing monthly for twenty-six months, who has a company laptop, a company email address, a manager, and a slot in the daily standup. On paper, a consultant. On the tests an Indian court actually applies, an employee, with reclassification reaching back to the first invoice.
None of this stops the round. It costs about eleven weeks, a rectification covenant, and a slice of the escrow. Which is roughly what it costs every time, because the documents that decide these questions are the ones founders write fastest and read least.
Every Indian startup must issue a written appointment letter in the prescribed format to every employee before they start work, under section 6(1)(f) of the Occupational Safety, Health and Working Conditions Code, 2020 and rule 6 of the central rules notified on 8 May 2026. The employment contract must assign intellectual property expressly, because copyright vests in the employer for employees but not for contractors, and it cannot restrain a departing employee from competing, because section 27 of the Indian Contract Act, 1872 makes post-employment non-competes void.
That is the short version. What follows is where each obligation comes from, which clauses do real work and which are decoration, what two courts decided in 2025 that changed the drafting, and the order to fix an existing set of contracts in.
On this page
The appointment letter stopped being optional, and the rules now prescribe the form
Offer letter, appointment letter, employment agreement: three documents, three jobs
The clauses that decide whether your equity story survives diligence
Non-compete, non-solicit and the bond: what Indian courts will enforce
Probation, notice and termination: the clause most employment contracts get backwards
Employee or contractor: the classification that costs the most to get wrong
The policies the contract points at, and which of them are compulsory
Where the employment contract meets the tax return
What it costs to get this wrong
Two boundaries first. This article is about the documents: what the contract has to say, what it cannot say, and what has to sit behind it. It is not a walk through the four labour codes themselves, which is covered in the new labour codes 2026 HR compliance checklist. And it addresses Indian employment law only. A startup employing people in the United States or the European Union is under a different regime, and nothing here transfers.
The appointment letter stopped being optional, and the rules now prescribe the form
Founders tend to hear "appointment letter" as a formality, something HR generates once probation clears. That reading was defensible under the old law, which required written particulars only in specific industries and above specific headcounts. It is not defensible now. So what actually changed?
What section 6(1)(f) of the POSH Code requires
Section 6(1) of the Occupational Safety, Health and Working Conditions Code, 2020 sets out the general duties of every employer. Most of the clauses read like a safety statute: keep the workplace free of hazards, meet the declared standards, provide annual health examinations to prescribed classes of employee, arrange disposal of hazardous and electronic waste.
Clause (f) is the one that reaches every startup. It requires the employer to issue a letter of appointment to every employee on appointment in the establishment, containing such information and in such form as may be prescribed. Where an employee was already on the roll when the Code commenced and held no such letter, the Code allowed three months to issue one.
Two things follow, and both are easy to miss. The duty attaches to every employee, not only to the narrower class of "workers" defined elsewhere in the codes, and not only above a headcount threshold. A four-person startup owes it. And the three-month window ran from commencement on 21 November 2025, so it closed on 21 February 2026. There is no cushion left to rely on.
Rule 6 moved the deadline to before the person joins
On 8 May 2026 the Ministry of Labour and Employment notified the four sets of central rules that put operational detail under the codes: the Code on Wages (Central) Rules, 2026, the Industrial Relations (Central) Rules, 2026, the Code on Social Security (Central) Rules, 2026, and the Occupational Safety, Health and Working Conditions (Central) Rules, 2026.
Rule 6 of the POSH central rules is the one to read twice. It provides that no employee shall be employed in an establishment unless an appointment letter has been issued in the prescribed format. Note the ordering. The Code said issue a letter on appointment. The rule says do not employ the person until the letter has been issued.
For a startup that hires the way most startups hire, that inverts the usual sequence. The common pattern is an offer letter by email, a start date two weeks out, a laptop on day one, and paperwork some time in month two when someone gets to it. Under rule 6 the paperwork is a precondition, not a follow-up. Frankly, this gets overlooked, because the change landed in the rules rather than in the codes, and most commentary published before May 2026 does not mention it at all.
What the prescribed format asks for
The notified format standardises the particulars an appointment letter carries, which is the point of prescribing one. Drafting for it means the letter states, at minimum, the things a labour inspector would otherwise have to reconstruct from payroll.
Particular the letter carries | Why the rule asks for it | What startups usually get wrong |
Designation and category of skill | Fixes which statutory classification the person falls into | Inflated titles that make a junior hire look supervisory |
Type of employment: regular, fixed-term or contractual | Fixed-term and contract staff carry different benefit rules | Calling a rolling contract a consultancy |
Wage rate and the components of the wage | Feeds the statutory wage definition and the fifty per cent test | Allowance-heavy structures that fail that test |
Social security entitlements, provident fund and state insurance | Puts the employee on notice of what is being contributed | Silence, because nobody registered the establishment |
Date of joining, and the term for a fixed-term hire | Starts the clock on gratuity and continuous service | Backdated joining dates used to tidy up a payroll gap |
Hours of work, leave entitlement and notice period | The terms most disputes actually turn on | Left to a handbook that is never issued |
Aadhaar appears in the format as an identity field, and it is optional where the employee would rather not share it. Collecting it anyway, and then storing it, pulls the startup into data-protection obligations that a smaller field set would have avoided.
Offer letter, appointment letter, employment agreement: three documents, three jobs
Ask ten founders what the difference is and you will get four answers, one of which is that there isn't one. There is, and the distinction decides what a court looks at when something goes wrong.
The offer letter binds you the moment it is accepted
An offer letter stating a role, a salary and a start date, accepted in writing, is a contract. Not a preliminary document, not a statement of intent. Withdrawing it after acceptance is a breach, and the fact that the person has not yet worked a day changes the measure of damages rather than the existence of the obligation.
That matters because offer letters get written casually. A line promising a bonus "as per company policy" imports a policy that may not exist. A line naming a number of stock options without naming a scheme, a vesting schedule or an exercise price creates an argument the company will lose. And an offer letter silent on notice period leaves the notice period to whatever the appointment letter says later, which the employee has not yet agreed to.
The better approach, in our view, is a short offer letter that expressly makes the offer conditional on execution of the appointment letter, with those terms attached. One set of terms, agreed once.
Why the appointment letter cannot wait for probation to end
The habit of issuing a confirmation letter at the end of probation and treating that as the real appointment letter is now a compliance failure rather than a filing preference. Rule 6 requires the letter before employment starts, and a probationer is an employee.
There is a second reason that has nothing to do with the rules. Probation clauses living in an offer letter and nowhere else are usually the weakest part of the arrangement. They say the employee is on probation for six months, extendable at the company's discretion, without saying what happens at the end of it, what standard applies, or what notice runs during it. When the company then wants to exit someone in month five, it finds that the shortest notice it can rely on is the one in the letter, and the letter is silent.
When a single document is enough
Plenty of startups run one document: an appointment letter carrying the statutory particulars in the prescribed format, then continuing into commercial terms, confidentiality, IP assignment and the rest. That works, and for a team under fifty it is usually the right call. Fewer documents, fewer contradictions between them.
The structure to avoid is the reverse. A long employment agreement carrying every clause except the prescribed particulars, plus a one-page appointment letter carrying the particulars and disagreeing with the agreement on notice period. That combination is common, and it is the one a departing employee's counsel enjoys most.
The clauses that decide whether your equity story survives diligence
An early-stage company is, in asset terms, mostly intellectual property and mostly people. The employment contract is where those two meet, and where the meeting usually goes wrong.
Section 17 of the Copyright Act does a lot of work, and then stops
Under section 17 of the Copyright Act, 1957, the author of a work is its first owner. Clause (c) carves out the employment case: where a work is made in the course of the author's employment under a contract of service, the employer is first owner, unless there is an agreement to the contrary.
So for salaried employees writing code, drafting copy or designing an interface as part of the job, copyright vests in the company by default. That default covers a great deal of what an early-stage startup produces, and it is why founders assume the IP question is handled.
Here's the thing. It covers copyright, it covers employees, and it covers work made in the course of employment. Everything outside those three boundaries needs express words.
Contractors, agencies and interns own what they make
A contract for services is not a contract of service, and that is precisely the distinction section 17(c) turns on. When a freelance designer, a development agency, or an unpaid intern with no employment relationship creates something for the company, the default is that they own the copyright and the company has at best an implied licence to use it for the purpose it was commissioned for.
Transferring it takes an assignment satisfying section 19: in writing, signed by the assignor, identifying the work, the rights assigned, the duration and the territory. An assignment silent on territory is presumed to extend to India only. One silent on period is presumed to run five years. Both defaults are worse than what the founder believes they bought.
Worth flagging: section 57 keeps the author's moral rights, the right to claim authorship and to restrain distortion, with the author whatever the assignment says. Those are not the company's, and no drafting makes them so.
Patents and inventions need their own words
There is no equivalent of section 17(c) in the Patents Act, 1970. An application is made by the true and first inventor, or by an assignee of the true and first inventor. Employment alone does not make the company an assignee.
For a startup filing anything, the contract needs a present assignment of inventions made in the course of employment, an obligation to execute further documents on request, and a power of attorney covering the case where the inventor has left and stopped answering email. That last one sounds like belt and braces until the first time a patent agent needs a signature from someone who resigned in anger.
The problem founders create before the company exists
The most valuable intellectual property in an early-stage company is usually the prototype, the first working version and the brand name, and all three were typically made before incorporation by a founder acting personally. Nothing in employment law reaches backwards. That IP belongs to the individual until it is assigned to the company in writing.
A founder IP assignment executed at incorporation costs an afternoon. Reconstructing one four years later, when a co-founder has left on bad terms and the trademark sits in their personal name, costs considerably more. If the brand name itself is the asset, the sequence and cost of protecting it is covered in trademark registration in India.
Non-compete, non-solicit and the bond: what Indian courts will enforce
This is where imported templates do the most damage. A US or UK employment agreement is built on the assumption that a reasonable post-employment restraint is enforceable. In India it is not, and no amount of narrowing the scope changes that. So what survives an exit, and what evaporates?
Section 27 makes the post-employment non-compete void, and 2025 confirmed it twice
Section 27 of the Indian Contract Act, 1872 is nine lines long and has not changed in a century and a half. Every agreement by which anyone is restrained from exercising a lawful profession, trade or business of any kind is, to that extent, void. The only statutory exception concerns the sale of goodwill of a business.
Indian courts have read that as a bright line rather than a reasonableness test. A restraint operating during employment is fine, because an employee owes fidelity while employed. A restraint operating after employment ends is void, and the court does not go on to ask whether two years was reasonable or whether the territory was narrow. The Supreme Court took that position on a post-service restraint in 1980 and again in 2006, and on 25 June 2025 the Delhi High Court applied it to a three-year clause barring a software engineer from working with any "business associate" of their former employer. The restriction fell.
The practical consequence for a founder is uncomfortable but clean. If your retention plan depends on a clause preventing engineers from joining a competitor, you do not have a retention plan. You have a paragraph.
What actually survives the exit
Three things do real work after the last working day, and it is worth being precise about which.
Confidentiality and trade secrets survive. An obligation not to use or disclose the employer's confidential information is not a restraint of trade, because it does not stop the ex-employee working anywhere. It stops them taking something with them. Courts enforce these, and the Delhi High Court in the June 2025 appeal was explicit that protecting proprietary information is a legitimate interest even where the non-compete is not. That is the clause to invest drafting effort in, and the definitions matter more than the covenant: what counts as confidential, what is carved out, how long the obligation runs. The same drafting logic applies to the standalone agreements covered in how to write an NDA that actually holds up.
Non-solicitation of employees and customers sits in a greyer zone. It is a restraint of a kind, but a narrower one, and Indian courts have enforced tightly drawn non-solicit clauses where the covenant protects a genuine connection rather than blocking competition generally. Twelve months is the range that survives argument. Three years across the entire client list is not.
Garden leave works, because it operates during employment. Putting a departing employee on paid notice and off client contact is not a post-employment restraint at all, and it buys the handover time the void non-compete was supposed to buy. It costs salary, which is why founders reach for the free clause instead.
The bond the Supreme Court upheld, and why yours probably fails
On 14 May 2025 the Supreme Court upheld an employment bond in an appeal brought by a public sector bank. The bond required a minimum three years of service, or payment of two lakh rupees in liquidated damages on premature resignation. The employee argued restraint of trade. The Court disagreed, on the ground that a negative covenant operating during the term of employment is not a restraint under section 27, and that the sum was a genuine pre-estimate of the recruitment and training cost a premature exit imposed.
Read alongside the Delhi High Court decision six weeks later, the pair draws the line cleanly. During employment, a well-evidenced bond is enforceable. After employment, a restraint is void. Founders instinctively reach for the second and skip the first.
Two conditions decide whether a bond of your own would survive. The sum has to be a genuine pre-estimate of loss, supported by evidence of what the training or onboarding actually cost, not a round number chosen to deter. And the commitment period has to be proportionate to that cost. A twenty-five lakh bond on a three-month bootcamp is a penalty, and Indian courts will read it down to the loss actually proved.
Probation, notice and termination: the clause most employment contracts get backwards
Almost every Indian startup employment contract says employment may be terminated by either party on one month's notice or salary in lieu. For a meaningful share of the people who sign it, that sentence is wrong, and the company finds out during the exit rather than the drafting.
Who on your payroll is a "worker", and why eighteen thousand rupees decides it
The Industrial Relations Code, 2020 protects "workers". The definition covers any person employed to do manual, unskilled, skilled, technical, operational, clerical or supervisory work. It excludes people employed mainly in a managerial or administrative capacity, and it excludes people employed in a supervisory capacity drawing wages above eighteen thousand rupees a month.
Run that against a typical Series A team and the result surprises founders. Engineers, designers, analysts, customer-support staff and sales executives are doing technical, operational or clerical work. They are workers, whatever they are paid, because the eighteen-thousand cap applies only to the supervisory limb. The people outside the definition are the ones genuinely running the business: heads of function with real managerial authority, and the founders themselves.
Role on a typical startup payroll | Worker under the IR Code? | What that changes on exit |
Backend engineer, any salary | Yes, technical work | Statutory notice and retrenchment compensation apply |
Designer or data analyst | Yes, technical or operational work | Same |
Customer support executive | Yes, clerical or operational work | Same |
Team lead, supervisory, wages above Rs 18,000 a month | No, excluded by the wage cap on the supervisory limb | Contract terms govern the exit |
Head of engineering with real managerial authority | No, managerial capacity | Contract terms govern the exit |
Founder or director | No | Contract and company law govern the exit |
Job titles do not settle this. Courts look at what the person actually does, so calling a support executive an "associate manager" moves nothing except the odds that an inspector reads the file more closely.
Retrenchment is not resignation, and section 70 sets the price
Where a worker has been in continuous service for at least a year, section 70 of the Industrial Relations Code, 2020 requires three things before the company can retrench them: one month's written notice stating the reasons, or wages in lieu of that notice; compensation equal to fifteen days' average pay for every completed year of continuous service, counting any part beyond six months as a full year; and notice to the appropriate government.
Prior government permission to retrench applies only to establishments with three hundred or more workers. Below that, notice and compensation are the whole obligation, which is the position essentially every startup is in. The mistake is not the threshold. It is assuming that a contractual notice clause replaces the statutory compensation. It does not. A contract can improve on the statutory floor and cannot go below it.
Standing orders follow the same three-hundred threshold, so most startups do not need certified standing orders. The contract and the policies do that work instead, which is exactly why they need to say something about misconduct, suspension and the process that runs before a dismissal.
Full and final settlement in two working days
Section 17 of the Code on Wages, 2019 sets the timing, and it is tighter than most payroll cycles. Where an employee has been removed, dismissed, retrenched, or has resigned, or where the establishment has closed, the wages payable must be paid within two working days.
Two working days. Not the next payroll run, not thirty days, not "after clearance". For a startup running a monthly cycle with manual approvals, that is a process change rather than a policy change: the exit checklist, the asset return, the leave encashment calculation and the recovery of any notice shortfall all have to finish inside forty-eight working hours of the last day.
The practical fix is to move the work forward. Compute the settlement during the notice period rather than after the last day, and treat the last day as a payment date rather than a starting gun.
Employee or contractor: the classification that costs the most to get wrong
Every lean startup has at least one. The designer who has been on a monthly retainer for two years, the engineer who prefers to invoice, the "consultant" hired to keep headcount off the deck before a raise. What does it actually cost if that classification is wrong?
The tests Indian courts actually apply
There is no single statutory definition that settles it. Indian courts look at the substance of the relationship across four dimensions: control over how the work is done rather than merely what is delivered; how far the person is integrated into the organisation; financial dependence, meaning whether this is the person's only or dominant source of income; and whether there is a continuing obligation to offer and accept work.
No single factor decides it, and the label on the document decides nothing at all. A person with a company laptop, a company email address, a reporting manager, fixed hours, a seat in the standup and a fixed monthly amount is an employee in substance, whatever the invoice says. A specialist engaged for a defined deliverable, who sets their own hours, uses their own tools and has other clients, is a contractor.
What reclassification costs, and how far back it reaches
This is the part founders underestimate, because the exposure is retrospective. Reclassification does not start from the date of the dispute. It reaches back to the start of the engagement.
The bill has three layers. Provident fund and state insurance contributions become payable for the whole period, employer share and employee share both, on the wages that should have been recorded. The Employees' Provident Fund Organisation adds interest on the arrears, and the Code on Social Security, 2020 provides for damages on top of the interest. And the reclassified employee can claim the statutory benefits they never received: paid leave, gratuity where the service qualifies, bonus, and maternity benefit.
There is a fourth cost that does not appear on any assessment order. In a funding round or an acquisition, a misclassified long-term contractor is an unquantified liability, and unquantified liabilities get escrowed. The compliance exposure that comes with a first hire, and the registrations that follow it, are set out in the first-year founder's compliance checklist.
Where the thresholds actually bite
Classification also decides when the startup crosses a registration threshold, because contractors do not count towards headcount and employees do. Provident fund coverage attaches at twenty employees. State insurance attaches at ten in most states, twenty in some, for employees drawing gross wages up to twenty-one thousand rupees a month, with a higher ceiling of twenty-five thousand for employees with disabilities.
A startup with fourteen employees and eight long-standing contractors believes it is below the provident fund threshold. Reclassify the eight and it has been above the threshold for two years, with contributions, interest and damages running from the month it crossed.
The policies the contract points at, and which of them are compulsory
Employment contracts routinely say the employee is bound by the company's policies as amended from time to time. That sentence is only as good as the policies behind it, and a handful of them are not optional at any headcount a startup is likely to reach.
POSH: ten employees, and the committee is not a formality
Section 4 of the Sexual Harassment of Women at Workplace (Prevention, Prohibition and Redressal) Act, 2013 requires every employer with ten or more employees to constitute an Internal Committee at each office or branch. The composition is prescribed: a presiding officer who is a woman employed at a senior level, at least two members from among employees committed to the cause of women or with relevant experience, and one external member from a non-governmental organisation or a person familiar with issues relating to sexual harassment. At least half the members must be women.
The count is ten employees, not ten women, and it includes contract staff and interns working at the workplace. Startups routinely miss the threshold because they count only the payroll.
Beyond constituting the committee, the employer files an annual report with the district officer under section 21, and a company also discloses compliance in its board report. Failure to constitute the committee or to comply with the duties draws a fine of up to fifty thousand rupees under section 26, with a higher penalty and possible cancellation of registration or licence on repetition.
Leave, maternity and the creche threshold
Maternity benefit runs to twenty-six weeks of paid leave for the first two children, carried into the Code on Social Security, 2020 from the earlier Act. A startup with fifty or more employees also has to provide creche facilities. Both obligations reach the contract, because the leave entitlement stated in the appointment letter has to be consistent with them.
Earned leave, casual leave and sick leave are largely a matter of state shops and establishments legislation, which is why a company with people in Bengaluru, Gurugram and Mumbai has three different statutory floors to satisfy. Writing one leave policy at the highest of the three is simpler than writing three, and costs less than the argument about which applies.
Employee data under the DPDP Act
Employee records are personal data, and the Digital Personal Data Protection Act, 2023 governs them. The useful part for employers is section 7(i), which treats processing for the purposes of employment, or to safeguard the employer from loss or liability such as protecting trade secrets and intellectual property, as a legitimate use. Consent is not required for that processing.
That exemption is narrower than it reads. It covers what is reasonably necessary for the employment relationship, and it does not switch off the rest of the statute: notice obligations, security safeguards, a grievance mechanism, and retention limits still apply. Background verification through a third party, continuous monitoring tools and biometric attendance systems all sit at the edge of it, and the contract and privacy notice should say what is collected and why. The wider obligations are set out in the DPDP Act compliance guide for founders.
Moonlighting, remote work and the policies nobody drafts until it is late
A clause requiring exclusive service during employment is enforceable, because it operates during the term. A clause banning any outside activity whatsoever, including open-source contribution and teaching, is both unenforceable in parts and a recruiting liability. Draft the exclusivity around conflict of interest and use of company time and assets, not around the employee's evenings.
Remote work raises two questions the standard template does not answer: which state's shops and establishments law applies to an employee who has never seen the registered office, and what happens to company data on a personal device. Neither has a tidy answer, and both are cheaper to address in the contract than in a dispute.
Policy or document | Trigger | Statutory basis |
Appointment letter in prescribed format | Every employee, from the first hire | POSH Code, 2020 s.6(1)(f); POSH Central Rules, 2026 r.6 |
Internal Committee and POSH policy | Ten or more employees | POSH Act, 2013 s.4 |
Provident fund registration | Twenty or more employees | Code on Social Security, 2020 |
State insurance registration | Ten or more in most states, twenty in some | Code on Social Security, 2020 |
Creche facility | Fifty or more employees | Code on Social Security, 2020 |
Certified standing orders | Three hundred or more workers | Industrial Relations Code, 2020 |
Privacy notice for employee data | Any employee records held digitally | DPDP Act, 2023 s.7(i) and related duties |
Where the employment contract meets the tax return
Founders treat HR compliance and tax compliance as separate files handled by separate people. They are not separate. Two of the more valuable reliefs available to an Indian startup are decided by what the employment documents say, and a third is decided by which document you signed at all.
Section 146 pays thirty per cent extra on employees you have already hired
Section 146 of the Income-tax Act, 2025, which carries forward the deduction that stood at section 80JJAA of the Income-tax Act, 1961, allows a deduction of thirty per cent of additional employee cost, for three consecutive tax years beginning with the year the employment is provided. It sits on top of the salary cost already deducted, so it is a genuine reduction rather than a timing benefit.
The conditions are all documentary. The additional employee must not draw total emoluments above twenty-five thousand rupees a month. They must be employed for at least two hundred and forty days in the tax year, reduced to one hundred and fifty for manufacturing of apparel, footwear and leather products. They must participate in a recognised provident fund. The emoluments must be paid other than in cash. And the deduction is inadmissible unless a report from an accountant, in the prescribed form, is furnished by the specified date.
Read that list against a startup that pays junior hires partly in cash-equivalent stipends, engages them as contractors so they sit outside the provident fund, or writes contracts that end at day two hundred and thirty. Every one of those choices forfeits the deduction, and none of them was made for a tax reason.
ESOPs, and the deferral only a certified startup gets
Employee stock options are taxed twice in India: as a perquisite when the option is exercised, and as capital gains when the share is sold. The first charge is the painful one, because the employee owes tax on a paper gain in an unlisted company they cannot sell.
Section 392(3) of the Income-tax Act, 2025 defers the employer's withholding on that perquisite, and section 289(3) sets the trigger: fourteen days after the earliest of sixty months from the end of the relevant tax year, the sale of the security, or the employee ceasing to be employed. Sixty months, not forty-eight.
The catch is who qualifies. The deferral is confined to an eligible startup referred to in section 140, which imports the certificate from the Inter-Ministerial Board, not merely recognition from the department. Most recognised startups do not hold that certificate, and their employees get no deferral at all. The distinction between recognition and certification, and what each is worth, is worked through in income tax for startups in India, and the recognition process itself in DPIIT Startup India registration.
An ESOP grant letter that promises a tax deferral the company cannot deliver is a misrepresentation to an employee, and one they will discover at exercise.
Which document you signed decides how you withhold
Salary is withheld at the employee's slab rate on a running estimate across the year, and the employer issues the annual salary certificate. Professional fees paid to a genuine contractor are withheld at a flat rate on each payment, and the contractor files their own return and claims their own expenses.
Getting that backwards is the tax-side symptom of the classification problem. A company withholding at contractor rates on someone a labour authority later treats as an employee has under-withheld on salary for the whole period, which is its own assessment with its own interest. The two exposures compound, and they are found by different regulators at different times.
What it costs to get this wrong
The individual penalties are not large by the standards of a funded company. The exposure is the aggregation, and the fact that most of it is retrospective.
Failure | Where the liability comes from | Shape of the exposure |
No appointment letter | POSH Code, 2020 s.6(1)(f) and the 2026 central rules | Penalty on inspection, plus no written terms to rely on in any dispute |
Settlement paid late | Code on Wages, 2019 s.17 | Fine, and a claim the employee can bring for the delay |
Contractor reclassified as employee | Code on Social Security, 2020 | Contributions, interest and damages back to the start of the engagement |
No Internal Committee at ten employees | POSH Act, 2013 s.26 | Up to Rs 50,000, higher on repetition, plus possible cancellation of registration |
No IP assignment from contractors | Copyright Act, 1957 s.17 and s.19 | The company does not own the asset it is being valued on |
Void non-compete relied on | Indian Contract Act, 1872 s.27 | No remedy at all when the employee joins a competitor |
Section 146 conditions broken | Income-tax Act, 2025 s.146 | Deduction of thirty per cent of additional employee cost lost for three years |
None of these is the kind of failure that closes a company. All of them are the kind that gets found in a data room, and the aggregate is what moves the escrow number in a term sheet. The same pattern shows up in the diligence checklist for startup funding rounds in India.
The order to fix this in
If a startup is starting from the position described at the top of this article, the sequence below is roughly the cheapest path out. It assumes a team under a hundred and no existing HR function.
Count the people, properly. Employees, contractors, interns and anyone invoicing monthly, with their start date, gross monthly pay and what they actually do. This single list decides every threshold that follows.
Classify each one honestly against the control, integration, dependence and continuity tests. Flag every contractor who has been engaged for more than twelve months on a monthly basis.
Issue appointment letters in the prescribed format to everyone currently unlettered, before anything else. This is the live statutory breach, and it is the cheapest to close.
Fix the wage structure so the components that count as wages are at least half of total remuneration, because provident fund, gratuity and bonus all compute off that base.
Get IP assignments signed by every contractor, agency and intern who has produced anything the company uses, and a founder assignment covering everything created before incorporation.
Rewrite the restrictive covenants. Delete the post-employment non-compete, strengthen the confidentiality definitions, narrow the non-solicit to twelve months, and add garden leave if the handover risk is real.
Constitute the Internal Committee if headcount is ten or more, appoint the external member, and calendar the annual report.
Register for provident fund and state insurance if the corrected headcount crosses the threshold, and regularise contributions from the month it was actually crossed rather than the month you noticed.
Rebuild the exit process to finish settlement inside two working days, computing it during the notice period rather than after the last day.
Set a calendar. Appointment letters at offer stage, POSH report annually, wage-structure review each appraisal cycle, and a classification review whenever a contractor passes twelve months.
Working through an entire employee file set, contract by contract, is a specific and unglamorous project, and it is the kind of work a founder does badly at eleven at night. Outsource360 runs HR due diligence audits and drafts the contracts and policies that come out of them, to current labour-code standards. If it would help to talk it through, book a consultation at outsource360.in or write to hr@outsource360.in.
Frequently asked questions
Is an appointment letter mandatory for every employee in India?
Yes. Section 6(1)(f) of the Occupational Safety, Health and Working Conditions Code, 2020 requires every employer to issue a letter of appointment to every employee on appointment, in the prescribed form. There is no headcount threshold and no exemption for startups. Rule 6 of the Occupational Safety, Health and Working Conditions (Central) Rules, 2026, notified on 8 May 2026, goes further and provides that no employee shall be employed unless the letter has been issued.
What is the difference between an offer letter and an appointment letter?
An offer letter proposes the engagement and becomes a binding contract once it is accepted. The appointment letter is the statutory document that has to carry the prescribed particulars: designation, category of skill, type of employment, wage and its components, social security entitlements, date of joining, hours, leave and notice period. Many startups run a single document that does both jobs, which is usually the cleaner choice. What does not work is two documents that disagree with each other.
Can a startup issue the appointment letter after probation ends?
No. A probationer is an employee, and rule 6 requires the letter before the person is employed. The practice of sending an offer letter at hiring and a "confirmation letter" six months later leaves the company without a compliant appointment letter for the whole probation period.
Are non-compete clauses enforceable in India?
Not after employment ends. Section 27 of the Indian Contract Act, 1872 makes void any agreement restraining a person from exercising a lawful profession, trade or business, and Indian courts apply that to post-employment restraints without asking whether the restriction was reasonable. The Delhi High Court held a three-year post-termination restriction unenforceable on 25 June 2025. A non-compete operating during employment is a different matter and is generally enforceable.
What restrictive covenants can an Indian employer actually enforce after an employee leaves?
Confidentiality and trade-secret obligations, because they restrain the use of information rather than the right to work. Narrowly drafted non-solicitation clauses covering specific customers or colleagues for a limited period, typically twelve months. Garden leave, because it operates during the notice period and so during employment. A general bar on joining competitors is not in that list.
Is an employment bond legal in India?
A bond that requires a minimum period of service during employment, with liquidated damages for early exit, can be enforced. The Supreme Court upheld one on 14 May 2025 where the sum reflected genuine recruitment and training costs. Two conditions matter: the amount has to be a real pre-estimate of loss the employer can evidence, and the service period has to be proportionate to it. A round number set to deter resignations is a penalty, and a court will read it down.
Does my startup own the code an employee writes?
Generally yes. Section 17(c) of the Copyright Act, 1957 makes the employer the first owner of a work made in the course of employment under a contract of service, unless the contract says otherwise. That covers copyright in code, designs and written material produced as part of the job. It does not cover work made outside the scope of employment, it does not cover patents, and it does not cover anyone who is not an employee.
Do we own what a freelancer or agency creates for us?
Not by default. A contractor works under a contract for services, which falls outside section 17(c), so the contractor is first owner of the copyright. Ownership passes only through an assignment satisfying section 19 of the Copyright Act, 1957: written, signed, identifying the work, the rights, the term and the territory. An assignment silent on territory is read as India only, and one silent on duration is read as five years.
What happens if we classify an employee as a contractor?
Reclassification is retrospective to the start of the engagement. Provident fund and state insurance contributions become payable for the whole period, with interest and damages, and the person can claim statutory benefits they never received, including paid leave, gratuity where the service qualifies, bonus and maternity benefit. There is a parallel tax exposure, because the company will have withheld at contractor rates rather than salary rates for the same period.
How many employees before we need an Internal Committee under the POSH Act?
Ten. Section 4 of the Sexual Harassment of Women at Workplace (Prevention, Prohibition and Redressal) Act, 2013 requires an Internal Committee at every workplace with ten or more employees, and the count includes contract staff and interns, not just people on payroll. The committee needs a woman presiding officer, at least two employee members, and one external member, with at least half the members women. Non-compliance draws a fine of up to fifty thousand rupees under section 26.
When does a startup have to register for provident fund and state insurance?
Provident fund coverage attaches at twenty employees. State insurance attaches at ten employees in most states and twenty in some, for employees drawing gross wages up to twenty-one thousand rupees a month, with a ceiling of twenty-five thousand for employees with disabilities. Once an establishment is covered it stays covered even if headcount later falls below the threshold.
How quickly must full and final settlement be paid?
Within two working days. Section 17 of the Code on Wages, 2019 requires wages to be paid within two working days where an employee has been removed, dismissed, retrenched or has resigned, or where the establishment closes. That is a process obligation rather than a payroll one, because leave encashment, asset recovery and notice adjustments all have to be finished inside that window.
Which of our employees count as "workers" under the labour codes?
More of them than founders expect. The Industrial Relations Code, 2020 defines a worker as anyone employed to do manual, unskilled, skilled, technical, operational, clerical or supervisory work. Engineers, designers, analysts and support staff are usually within it regardless of salary. The exclusions are people employed mainly in a managerial or administrative capacity, and people in a supervisory capacity drawing wages above eighteen thousand rupees a month. The wage cap applies only to the supervisory limb, not to technical or operational roles.
Does a startup need certified standing orders?
Only at three hundred or more workers, under the Industrial Relations Code, 2020. Below that threshold the employment contract and the company's own policies carry the weight, which is why they should address misconduct, suspension and the process that runs before a dismissal rather than leaving those to discretion.
Do we need employee consent to process their personal data under the DPDP Act?
Not for ordinary employment processing. Section 7(i) of the Digital Personal Data Protection Act, 2023 treats processing for the purposes of employment, or to safeguard the employer from loss or liability such as protecting trade secrets and intellectual property, as a legitimate use for which consent is not required. The rest of the statute still applies, including notice, security safeguards, grievance redressal and retention limits, and processing has to stay within what is reasonably necessary for the employment purpose.
Does the employment contract affect our tax position?
Directly. Section 146 of the Income-tax Act, 2025, the successor to section 80JJAA of the Income-tax Act, 1961, gives a deduction of thirty per cent of additional employee cost for three consecutive tax years, but only for employees drawing not more than twenty-five thousand rupees a month, employed at least two hundred and forty days in the year, paid other than in cash, and participating in a recognised provident fund. Hiring the same person as a contractor, or on a contract that ends short of the day count, forfeits it.
Do all recognised startups get the ESOP tax deferral for employees?
No. Section 392(3) of the Income-tax Act, 2025 confines the deferral of withholding on the option perquisite to an eligible startup referred to in section 140, which requires a certificate from the Inter-Ministerial Board rather than departmental recognition alone. Most recognised startups do not hold that certificate. The deferral, where it applies, runs to fourteen days after the earliest of sixty months from the end of the relevant tax year, the sale of the security, or the employee leaving.
References
Occupational Safety, Health and Working Conditions Code, 2020, section 6(1), duties of employer including clause (f) on letters of appointment, in force 21 November 2025, indiacode.nic.in.
Occupational Safety, Health and Working Conditions (Central) Rules, 2026, rule 6, appointment letter in the prescribed format, notified 8 May 2026 by the Ministry of Labour and Employment, labour.gov.in.
Code on Wages, 2019, section 2(y) definition of wages and the fifty per cent test, and section 17 on the time limit for payment of wages on removal, dismissal, retrenchment or resignation.
Industrial Relations Code, 2020, definition of worker including the exclusion of managerial and administrative roles and of supervisory roles above Rs 18,000 a month; section 70 on conditions precedent to retrenchment; the three hundred worker threshold for standing orders and for prior permission.
Code on Social Security, 2020, provident fund and state insurance coverage, gratuity including pro-rata entitlement for fixed-term employees after one year, maternity benefit of twenty-six weeks, the fifty employee creche threshold, and interest and damages on default in contributions.
Indian Contract Act, 1872, section 27, agreements in restraint of trade void, indiacode.nic.in.
Delhi High Court, judgment of 25 June 2025 in FAO 167/2025, holding a three-year post-termination non-compete and non-solicit covenant unenforceable under section 27 while recognising confidential information as a protectable interest.
Supreme Court of India, judgment of 14 May 2025 in the Vijaya Bank appeal, upholding a minimum-service employment bond with liquidated damages of Rs 2,00,000 as a covenant operating during employment.
Copyright Act, 1957, section 17 on first ownership, section 19 on the mode of assignment and the statutory presumptions as to term and territory, and section 57 on moral rights, copyright.gov.in.
Patents Act, 1970, application for a patent by the true and first inventor or an assignee, ipindia.gov.in.
Sexual Harassment of Women at Workplace (Prevention, Prohibition and Redressal) Act, 2013, section 4 on the Internal Committee, section 21 on the annual report, and section 26 on penalties, wcd.gov.in.
Digital Personal Data Protection Act, 2023, section 7(i) on processing for employment purposes as a legitimate use, meity.gov.in.
Income-tax Act, 2025 (Act No. 30 of 2025), in force 1 April 2026, sections 63, 140, 146, 289 and 392, as amended by the Finance Act, 2026 (Act No. 4 of 2026), incometaxindia.gov.in.
Income-tax Act, 1961, section 80JJAA, as it applied before 1 April 2026 and as carried forward into section 146 of the Income-tax Act, 2025.
Employees' Provident Fund Organisation, coverage and contribution guidance, epfindia.gov.in, and Employees' State Insurance Corporation, coverage and wage ceiling guidance, esic.gov.in.
Disclaimer
This article is for educational and general business information purposes only and does not constitute professional legal, financial, or tax advice. It addresses Indian employment law as it stood on the date above, and thresholds, forms, wage ceilings and penalties change by amendment, notification and state rule, sometimes mid-year. Several matters in this article vary by state rather than nationally, including shops and establishments registration, leave entitlements and the headcount at which state insurance attaches, and the position for a specific startup depends on where its people actually work. Two points are flagged as unsettled at the date of writing and are treated as such in the text: the precise field set and form reference of the appointment-letter format prescribed under the 2026 central rules, which should be checked against the notified rules themselves before a template is rolled out; and the interaction between the central rules and state rules where a state has notified its own. Case references are given by court, date and case number rather than by party name where the party is an individual. Consult a qualified employment lawyer or chartered accountant before acting on any threshold, clause, form or date set out here.
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