ESOP structuring for Indian startups: rules, vesting and tax
Authored by - Souvik Das, Executive at Outsource360 The term sheet arrived on a Tuesday. By Friday the diligence list had a line on it that nobody at the company had thought about in three years: "Provide the ESOP scheme, the shareholder resolution approving it, the grant letters, and the register of options."
There was no scheme. There were forty-one offer letters, each with a paragraph that said the employee would receive stock options equal to some number of shares, vesting over four years, subject to board approval. Board approval had never been minuted. No resolution had been passed. The cap table the founders showed investors had a line called "ESOP pool, 10%", and that line existed only in a spreadsheet.
That is not a paperwork problem. Under section 62(1)(b) of the Companies Act, 2013, a company issues shares to employees under a scheme of employees' stock option only where the shareholders have approved it. Without that resolution there is no scheme, and without a scheme those forty-one paragraphs are a promise the company made in writing and cannot lawfully perform on the terms it wrote. The fix was retrospective, expensive, and it delayed the round by seven weeks.
Three more things surfaced in the same review.
The co-founder who ran engineering held 12 per cent of the equity and had been promised a further grant. Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014 excludes a director holding more than 10 per cent of the outstanding equity shares from the definition of "employee" for ESOP purposes, and it excludes promoters outright. The company was DPIIT-recognised and inside ten years of incorporation, so the exemption did save that grant. Nobody had known the exemption existed, or that it runs out.
An employee who had left in January was told she had ninety days to exercise. She exercised. The company then discovered it owed tax deduction at source on a perquisite of roughly Rs 14 lakh, computed on shares she could not sell, on a salary that had already stopped. Somebody had to fund that number in cash, in the same month, and the grant letter said nothing about who.
And the founders believed they had the startup tax deferral, because they had a DPIIT recognition certificate framed in reception. They did not have it. The deferral in section 392(3) of the Income-tax Act, 2025 is confined to an eligible start-up referred to in section 140, and section 140(16)(b)(iii) requires a certificate of eligible business from the Inter-Ministerial Board. Recognition is one application. The certificate is a different application, decided by a different body, on a harder test. Public compilations of the Board's approvals put the count at roughly 3,700 certificates against more than 1.97 lakh recognised startups.
Here's the thing about all four failures. Each one was cheap to prevent at the moment the pool was created and expensive to unwind afterwards, and none of them is unusual.
ESOP structuring for Indian startups runs on two statutes. Company law governs the grant: section 62(1)(b) of the Companies Act, 2013 read with Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014, which requires shareholder approval, sets a minimum one-year gap between grant and vesting, and restricts who may hold options. Tax law governs the outcome: the spread at exercise is a perquisite under section 17(1)(d) of the Income-tax Act, 2025, and the gain on sale is capital gains, with cost of acquisition carried over under section 73.
That is the frame. What follows is the approval chain in the order it has to run, how to size a pool without paying for it twice, what the law actually says about vesting (far less than founders assume), the three tax events and who pays at each, the sixty-month deferral and the certificate that gates it, the liquidity routes and what the Finance Act, 2026 changed about them, the cross-border position in both directions, and what happens to every unexercised option if the company closes.
On this page
What Indian law actually recognises as an ESOP
The approval chain, in the order it has to run
Sizing the option pool without paying for it twice
Vesting: one statutory rule, and everything else is contract
Tax implications: the three moments that matter
The sixty-month deferral, and the certificate almost nobody holds
Liquidity: buyback, secondary sale, and what the Finance Act, 2026 changed
Cross-border ESOPs run in both directions
The listed-company overlay and the IPO runway
What happens to ESOPs when the company is wound up or struck off
One boundary. This article is about equity granted to employees of an Indian company. If you are earlier than that, registering a startup in India covers incorporation, and the section 140 tax holiday itself is set out in the guide to income tax for startups under section 80-IAC. This piece is about the option pool.
What Indian law actually recognises as an ESOP
Ask ten founders what an ESOP is and you'll get ten answers, most of them borrowed from a Delaware cap table. So what does Indian law actually let a company issue? Something narrower than the American instrument, and the difference decides what you can grant, to whom, and at what price.
Section 62(1)(b) and Rule 12: what makes a grant real
Section 62 of the Companies Act, 2013 governs further issue of share capital. Sub-section (1)(b) permits a company to offer shares to employees under a scheme of employees' stock option, subject to a special resolution and to prescribed conditions. Those conditions are Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014, and they are the operative law for every unlisted Indian company.
The word "scheme" carries weight. An ESOP in Indian law is a plan document approved by shareholders, under which the board grants options to identified employees. It is not a clause in an employment contract, and it is not a spreadsheet line. A grant made outside an approved scheme is not an option in the statutory sense, whatever the offer letter says.
Rule 12(2) sets out what the explanatory statement to the resolution must disclose, and the list is longer than most first drafts allow for: the total number of options to be granted, the classes of employees entitled to participate, the appraisal process for determining eligibility, the requirements and period of vesting, the maximum period within which options must be vested, the exercise price or the formula for arriving at it, the exercise period and the process of exercise, the lock-in period, the maximum number of options to be granted per employee and in aggregate, the method the company will use to value its options, and the conditions under which options vested may lapse.
Read that list once and the design problem becomes obvious. You cannot pass the resolution until you have decided the plan. Most companies do it the other way round, pass a thin resolution to get the pool on the cap table, and then discover at diligence that the terms they have been granting on are not the terms the shareholders approved.
ESOP, RSU, phantom stock and sweat equity are four different instruments
The vocabulary gets used loosely, and the tax follows the instrument rather than the label.
An option is a right without an obligation, granted at a predetermined price. That is not a drafting preference; it is the statutory definition in section 17(4)(e) of the Income-tax Act, 2025. A restricted stock unit is a promise to deliver shares on vesting, with no exercise decision and typically no exercise price, which an unlisted Indian company usually implements as an option with a nominal exercise price rather than as a true RSU. Phantom stock is a cash bonus indexed to share value, taxed as salary when paid, with no shares issued and no company-law approval needed. Sweat equity shares are shares issued at a discount or for non-cash consideration for know-how or intellectual property, governed by section 54 of the Companies Act, 2013 and its own rule, and they are issued rather than optioned.
Instrument | What the holder gets | Governing provision | When tax bites |
Employee stock option (ESOP) | A right, not an obligation, to buy shares at a fixed price after vesting | Section 62(1)(b), Companies Act, 2013 and Rule 12 | Perquisite at exercise, capital gains at sale |
Restricted stock unit (RSU) | Shares delivered on vesting, no purchase decision | Usually run as an option at nominal exercise price in an unlisted Indian company | Perquisite when the shares are allotted, capital gains at sale |
Phantom stock or stock appreciation rights | Cash equal to the increase in share value. No shares, no dilution | Contract only. No section 62 approval required | Salary income when the cash is paid |
Sweat equity shares | Shares issued at a discount or for know-how or intellectual property | Section 54, Companies Act, 2013 and the Sweat Equity Rules | Perquisite on issue under section 17(1)(d), capital gains at sale |
Phantom stock deserves a mention it rarely gets. For a company that wants to reward a small senior group without touching the cap table or running a Rule 12 process, it is simpler and faster, and the cost is that the payout is ordinary salary income at slab rates with no capital-gains treatment at any point. The better approach, in our view, is to reserve it for consultants and overseas contractors who cannot cleanly hold Indian shares, and to use real options for employees.
Who is an eligible employee, and the ten-year startup exemption
Rule 12 defines "employee" for ESOP purposes as a permanent employee of the company working in or outside India, a director whether whole-time or not but excluding an independent director, and an employee or director of a subsidiary, holding or associate company. Then it takes three categories back out.
An employee who is a promoter or belongs to the promoter group cannot hold options. A director who, alone or through a relative or through any body corporate, directly or indirectly holds more than 10 per cent of the outstanding equity shares cannot hold options. Independent directors are excluded outright, and that exclusion has no startup carve-out.
The carve-out that does exist is the one most founder teams need. For a startup company as defined in the Department for Promotion of Industry and Internal Trade notification G.S.R. 127(E) dated 19 February 2019, the promoter and the ten-per-cent-director exclusions do not apply for ten years from the date of incorporation or registration. That period was five years originally and was doubled by the Companies (Share Capital and Debentures) Amendment Rules, 2019, notified as G.S.R. 574(E) on 16 August 2019.
So a founder can hold options in their own company, if the company is a recognised startup and if the grant happens inside the window. What most people miss is that the window is measured from incorporation, not from recognition, and it does not pause. A company incorporated in 2017 has until 2027, whether or not it applied for recognition in 2023. If founder options are part of the plan, the grant date matters more than the vesting date, and it should be diarised the way a filing deadline is. Recognition itself is a separate exercise; the process and what it does and does not buy you are set out in the guide to DPIIT startup recognition.
One structural point that catches people choosing an entity. A limited liability partnership has no share capital and therefore cannot issue stock options at all, no matter how startup-like it is. An LLP can be an eligible start-up for the section 140 deduction, and it still cannot run an ESOP. If employee equity is on the roadmap, the entity question is settled before the pool question. The trade-offs are compared in private limited versus LLP versus OPC.
The approval chain, in the order it has to run
Why does a process with six steps regularly take four months? Because two of the steps depend on a valuation, one depends on a board meeting that needs notice, and the company usually starts at step four.
The sequence begins with the plan document. Draft the scheme first: pool size, eligibility, vesting, exercise price mechanics, exercise window, leaver treatment, lapse conditions, administration. Every one of those has to be disclosed in the explanatory statement, so the plan is the input to the resolution rather than an output of it.
Then the board approves the scheme and calls the general meeting. Then the shareholders approve. A public company needs a special resolution. A private company may pass an ordinary resolution instead, under the Ministry of Corporate Affairs exemption notification G.S.R. 464(E) dated 5 June 2015, and that single relaxation is worth knowing because it changes the arithmetic when an investor holds a blocking stake. Fair warning: the exemption is available only to a private company that is not in default of its annual filings, so a company sitting on unfiled AOC-4 and MGT-7 forms loses it exactly when it needs it.
Two grants need their own separate resolution under Rule 12(5), whatever the main scheme said. Options granted to employees or directors of a subsidiary, holding or associate company need a separate shareholder approval. So does a grant to any identified employee that, during any one year, equals or exceeds 1 per cent of the issued capital at the time of grant. That 1 per cent trigger is the one senior hires walk into, and it is worth checking before the offer goes out rather than after it is signed.
Where a special resolution has been passed, it is filed with the Registrar in Form MGT-14 within thirty days under section 117. Any later variation of the terms of a scheme already approved requires a fresh special resolution under Rule 12(3), which is the reason a well-drafted scheme leaves administrative discretion with the board rather than hard-coding numbers the company will want to change.
After that, the grant letters go out, and the company opens the Register of Employee Stock Options in Form SH-6 at its registered office. It is a statutory register, not a spreadsheet, and it is the first document a buyer's counsel asks for. Rule 12(9) then requires the Board's report for each year to disclose options granted, options vested, options exercised, shares arising, options lapsed, the exercise price, variations of terms, money realised on exercise, options in force, and employee-wise details for key managerial personnel and for anyone receiving 5 per cent or more of the options granted in that year.
When an employee exercises, the company allots the shares and files a return of allotment in Form PAS-3 within thirty days. That filing is where the option finally becomes equity on the register of members. Missing it is a common and entirely avoidable defect, and the deadline sits alongside the rest of the calendar in the annual ROC compliance calendar.
Sizing the option pool without paying for it twice
Ten to fifteen per cent is the number the market uses for an early-stage Indian startup, and it is a reasonable default. But is the percentage really the decision? Not quite. It is the least interesting part of it.
The interesting part is when the pool is created relative to a funding round, because that decides who pays for it. A pool created before the round out of the pre-money valuation dilutes the existing shareholders alone; the incoming investor's percentage is calculated after the pool exists, so the investor's money buys the same stake at the same price regardless. A pool created after closing, out of the post-money capital, dilutes everyone including the new investor.
Investors ask for the first. Founders should understand that when a term sheet says "a 10 per cent option pool on a fully diluted, pre-money basis", the pool is being funded entirely by the founders and the earlier shareholders, and its cost is a real reduction in the effective pre-money price. Model it that way before agreeing the headline valuation, not afterwards. The mechanics of the round itself, including the resolutions and filings that sit alongside a pool expansion, are covered in the funding-round compliance checklist.
The practical reality is that pool sizing is a hiring-plan exercise, not a benchmark exercise. Take the next eighteen to twenty-four months of senior hires, attach a target percentage to each role, add the top-ups you owe existing staff, add a buffer for the one hire you cannot predict, and see what the total comes to. If it comes to 6 per cent, do not reserve 15 per cent because a blog said so. Unallocated pool is dilution you have already paid for and are not using.
And two sizing errors recur almost everywhere. The first is granting in absolute share numbers without telling employees the denominator, which turns a genuine benefit into a source of suspicion the first time someone works out their percentage. The second is refusing to top the pool up at each round, so that by Series B the pool is exhausted and every new senior hire triggers a fresh shareholder approval and a fresh negotiation with investors who now hold a veto.
Vesting: one statutory rule, and everything else is contract
Here's what surprises most founders. How much of the standard four-year schedule is actually mandated by Indian law? Almost none of it. Rule 12(6)(a) sets a minimum period of one year between the grant of options and the vesting of those options, and that is essentially the whole of it. Everything else in a vesting schedule is a commercial term you are choosing.
Rule 12(6)(b) leaves the company free to specify a lock-in period for shares issued on exercise. Rule 12(6)(c) provides that option holders have no right to dividend, to vote, or to any shareholder rights until the option is exercised. Rule 12(8) makes options non-transferable, incapable of being pledged, hypothecated, mortgaged or otherwise encumbered, and exercisable only by the employee.
The four-year schedule and the one-year cliff
The standard Indian schedule mirrors the global one: four years total, a one-year cliff, then monthly or quarterly vesting over the remaining thirty-six months. Twenty-five per cent lands on the first anniversary and the rest accrues from there.
That structure survives because it does two jobs at once. The cliff satisfies the statutory one-year minimum without any extra drafting, and it filters out the hire who leaves in month seven. Monthly accrual after the cliff avoids the retention cliff-edge that annual vesting creates, where an employee who wants to leave in month twenty-two has an expensive reason to stay four more months and no reason at all to be productive during them.
Variants worth considering, and each has a cost. Back-weighted vesting (10, 20, 30, 40 across four years) improves retention at the price of looking mean in a competitive offer. A five-year schedule buys a longer runway and reads as a red flag to candidates who have seen four. Milestone vesting tied to revenue or product delivery sounds rigorous and turns into a dispute the moment the milestone is missed for reasons outside the employee's control. Time-based vesting is boring, and boring is usually right here.
Exercise price, exercise window and the leaver who cannot pay
Rule 12(4) gives the company freedom to determine the exercise price, subject to complying with the applicable accounting policies under section 133 of the Companies Act, 2013. There is no statutory floor at fair market value the way there is in some jurisdictions. Indian startups commonly grant at face value, at Re 1, or at the price of the last round, and each choice has consequences.
Grant at face value and the employee's cash outlay at exercise is trivial, which is kind. It also maximises the spread between exercise price and fair market value, and that spread is the taxable perquisite. Grant at the last round price and the perquisite shrinks to nothing on day one, at the cost of asking employees to write a real cheque for shares they cannot sell. Most Indian plans grant low, which means most Indian employees face a tax bill rather than a purchase price.
Then there is the exercise window, which is the single most consequential clause in a plan document and the one that gets the least attention at drafting. Rule 12(8) provides that on resignation or termination, options not vested on that day expire, and vested options may be exercised in accordance with the scheme. So the scheme decides. Thirty days after the last working day is punitive and will be read as such. Ninety days is the market standard. An extended window of several years for a good leaver is genuinely employee-friendly and is starting to appear in
Indian plans, and it costs the company nothing in cash.
The problem the ninety-day window creates is the one in the opening scenario. An employee who exercises within ninety days of leaving pays tax on a perquisite computed on the fair market value of shares in an unlisted company with no market. The salary that would have absorbed the withholding has stopped. Unless the plan or the settlement addresses it, the leaver either funds a five- or six-figure tax bill out of pocket for an illiquid asset, or forfeits options they earned. Neither outcome is good for the company's reputation as an employer, and both are foreseeable at drafting. The interaction between the plan and the employment contract is worth checking in the same pass; the wider framework is in the guide to employment contracts and HR compliance for Indian startups.
Acceleration, and what an investor will actually negotiate
Acceleration clauses bring forward vesting on a trigger, and there are two shapes. Single trigger accelerates on a change of control alone. Double trigger accelerates only if there is a change of control and the employee is terminated without cause or resigns for good reason within a defined period afterwards.
Acquirers dislike single trigger, for a reason that is easy to state: it hands the acquirer a fully vested team on closing day with nothing left to retain them. But double trigger is the market position and the one an investor will accept without argument. Our recommendation is double trigger for the whole employee base, with single trigger reserved, if at all, for a small number of founder-level grants where the acquirer is expected to replace the role anyway.
Rule 12(8) also settles the two cases plans most often forget. On the death of an option holder, all options granted and outstanding vest in the legal heirs or nominees on that date. Where an employee suffers permanent incapacity while in employment, all options granted and outstanding vest on the date of incapacity. Those are statutory, not optional, and a plan that says otherwise is wrong on its face.
Tax implications: the three moments that matter
The Income-tax Act, 2025 replaced the Income-tax Act, 1961 on 1 April 2026 and renumbered every section. Did the substance of ESOP taxation change with it? Barely. The citations did, entirely. If you are reading an article that cites section 17(2)(vi) or section 192(1C), you are reading about a repealed statute. The mapping and what else moved with it is set out in the guide to the new Income-tax Act, 2025.
Grant and vesting are not taxable events
Nothing happens for tax purposes when an option is granted, and nothing happens when it vests. There is no income, no perquisite and no withholding at either moment, because the employee has acquired a right and not a security.
This is worth saying plainly because employees frequently believe otherwise, and because a company that reports vesting in a payroll system as though it were income creates a Form 16 problem it then has to unwind. Vesting is a contractual milestone. The tax system does not see it.
Exercise: the perquisite under section 17(1)(d)
Section 17(1)(d) of the Income-tax Act, 2025 brings into charge, as a perquisite, the value of any specified security or sweat equity shares allotted or transferred, directly or indirectly, by the current or former employer, free of cost or at a concessional rate.
Section 17(4)(h) fixes the amount. The value is the fair market value of the security on the date on which the option is exercised, reduced by the amount actually paid by or recovered from the employee. That spread is salary income, taxed at the employee's slab rate, and the employer withholds on it under section 392(1) as part of salary.
Two mechanics matter. The valuation date is the exercise date, not the vesting date and not the allotment date, and section 17(4)(a) leaves the method to be prescribed by rules. For unlisted shares the prescribed method has long required a merchant banker's valuation made on the exercise date or on a date not more than 180 days earlier, and the prescribing power carries forward into the Income-tax Rules, 2026; confirm the current rule reference before you rely on a specific number, because the rules were renumbered alongside the Act.
The second mechanic is cash. The withholding is real money, due from the employer, on income the employee has received in the form of an illiquid share. For a serving employee it comes out of that month's salary, which is uncomfortable but workable. But for a leaver it has to come from somewhere else, and a plan that does not say where is a plan with a gap in it.
Sale: capital gains, and the cost that carries across
When the employee eventually sells, the gain is capital gains, and the cost of acquisition is not what they paid. Section 73 of the Income-tax Act, 2025, at serial number 4 of its table, provides that for a capital asset being a specified security or sweat equity share referred to in section 17(1)(d), the cost of acquisition is the fair market value taken into account for the purposes of that clause.
So the value already taxed as a perquisite becomes the cost base, and the same rupee is not taxed twice. The gain is the sale price minus the exercise-date fair market value.
For unlisted shares the holding period runs from the date of allotment, and more than twenty-four months makes the gain long-term, taxed at 12.5 per cent under section 197(1)(b) with no indexation. Twenty-four months or less and the gain is short-term, added to total income and taxed at slab rates. Once the company lists and the shares are sold on a recognised exchange with securities transaction tax paid, the listed regime applies instead: twelve months to long-term, and the sections dealing with listed capital gains take over.
Event | What is taxed | Rate | Who pays and how |
Grant | Nothing | Nil | No action |
Vesting | Nothing | Nil | No action |
Exercise | Fair market value on the exercise date less the amount paid, as a perquisite under section 17(1)(d) | Employee's slab rate | Employer withholds under section 392(1). Deferral possible under section 392(3) for an eligible start-up |
Sale, unlisted, held more than 24 months | Sale price less the exercise-date fair market value, under section 73 | 12.5 per cent under section 197(1)(b), no indexation | Employee, in the return for that tax year |
Sale, unlisted, held 24 months or less | Same computation, short-term | Slab rate | Employee, in the return for that tax year |
Buy-back by the company | Consideration less cost of acquisition, as capital gains under section 69 | Capital-gains rates, plus an additional tax if the seller is a promoter | Employee. Company deducts tax at source as applicable |
The sixty-month deferral, and the certificate almost nobody holds
There is a genuine relief in the Act for employees of qualifying startups, and it is better than the version most articles describe. Is your company one of them? Probably not, and the reason comes down to a single certificate.
Section 392(3) of the Income-tax Act, 2025 provides that a person being an eligible start-up referred to in section 140, responsible for paying income of the nature specified in section 17(1)(d), shall deduct or pay tax on that income on the basis of the rates in force for the tax year in which the specified security or sweat equity share is allotted or transferred, within the time specified in section 289(3).
Section 289(3) sets the clock. The tax is payable within fourteen days after the earliest of three dates: the expiry of sixty months from the end of the relevant tax year, the date of sale of the security by the employee, or the date the employee ceases to be an employee of the employer who allotted the shares.
Sixty months, not forty-eight. The forty-eight-month figure that appears across the internet is the 1961 Act formulation, which ran from the end of the relevant assessment year. The 2025 Act works in tax years, and expressing the same window from the end of the tax year makes it sixty. The economics are identical; the number in your calendar is not.
Two features of the deferral are easy to miss and both favour the employee. The rate is locked to the tax year of allotment, so a later increase in slab rates does not reach back. And the deferral is a deferral of payment, not of the charge, so the perquisite still belongs to the year of exercise for every other purpose.
And now the gate. "Eligible start-up referred to in section 140" imports the whole of the section 140(16)(b) definition: incorporated on or after 1 April 2016 but before 1 April 2030, total turnover not exceeding three hundred crore rupees in the tax year, and holding a certificate of eligible business from the Inter-Ministerial Board. The turnover cap was one hundred crore until the Finance Act, 2026 substituted three, with effect from 1 April 2026.
DPIIT recognition is not that certificate. Recognition is the entry ticket to the Startup India framework; the Inter-Ministerial Board certificate is a separate application assessed on innovation and scalability, and it is the thing section 140 requires. Compilations of the Board's approvals put the number of certificates at roughly 3,700 against more than 1.97 lakh recognised startups, which is under 2 per cent. If your company does not hold one, your employees do not have the deferral, and telling them otherwise in a grant letter is a problem you will own later.
One more trap sits in the definition. An eligible start-up under section 140 can be a company or a limited liability partnership. An LLP cannot issue specified securities to employees, so the deferral is available in law to a class of entity that cannot generate the income it defers. That is a drafting artefact rather than an opportunity.
Liquidity: buyback, secondary sale, and what the Finance Act, 2026 changed
An option that vests, gets exercised and then sits on a share certificate for nine years is not compensation. It is a story about compensation. So when does the story become money? Only at a liquidity event, and the Indian market has finally started providing those at scale.
By one industry compilation, seven Indian startups bought back employee stock worth close to 220 million dollars in the first quarter of 2026, more than the whole of 2024 and more than the whole of 2025, taking cumulative ESOP buybacks since 2020 to roughly 2 billion dollars. Whether that pace holds is anyone's guess. What it has already done is shift employee expectations: candidates now ask about the buyback policy in the interview, and "we did one last year" is a recruiting asset.
Three routes exist, and they are taxed differently.
A company buy-back under section 68 of the Companies Act, 2013 is the cleanest to run, because the company controls it. Its tax treatment has moved twice in two years. From 1 October 2024 buy-back proceeds were treated as a deemed dividend in the shareholder's hands at slab rates, with no deduction for cost, and the cost converted into a capital loss. The Finance Act, 2026 reversed that. Section 69 of the Income-tax Act, 2025 as substituted with effect from 1 April 2026 restores capital-gains treatment: the difference between the cost of acquisition and the consideration received is capital gains in the year the company purchases the shares.
There is a sting in the new section that matters for senior people. Section 69(2) imposes an additional income-tax where the seller is a promoter, on top of the normal capital-gains tax: 2 per cent for a domestic company promoter and 10 per cent for any other promoter on short-term gains, and 9.5 per cent and 17.5 per cent respectively on long-term gains. And section 69(3)(b)(ii) defines "promoter", for an unlisted company, to include a person holding directly or indirectly more than 10 per cent of the shareholding. An employee who has crossed that threshold through a large early grant is inside that definition. Check the cap table before the buy-back price is agreed, not after.
A secondary sale to an incoming or existing investor is the second route. The employee sells directly, the company issues nothing, and the transaction is plain capital gains under the rules described above. Pricing is negotiated, usually at a discount to the round price, and the company's role is limited to waiving transfer restrictions and updating the register. Where the buyer is a non-resident, the pricing guidelines and reporting under the Foreign Exchange Management (Non-debt Instruments) Rules, 2019 apply to the transfer, which is the same machinery covered in the guide to FDI in India.
The third route is a listing, and it is the only one that gives an employee a genuine market rather than a periodic window.
Liquidity route | Who buys | Tax on the employee | Practical constraint |
Company buy-back, section 68 Companies Act | The company, out of free reserves or securities premium | Capital gains under section 69, plus additional tax if the seller is a promoter | Statutory limits on quantum and frequency, and it consumes company cash |
Secondary sale in a funding round | Incoming or existing investors | Capital gains, 12.5 per cent long-term on unlisted shares | Needs an investor who wants secondary, and usually prices at a discount |
Sale after listing | The public market | Listed-share capital-gains regime, 12 months to long-term | Lock-in periods and the SEBI framework apply from the DRHP onwards |
Phantom stock payout | The company, as cash | Salary income at slab rates, no capital-gains treatment | Not equity. No upside beyond the formula in the contract |
Cross-border ESOPs run in both directions
Two distinct exchange-control questions hide behind one word, and confusing them is common. Is your Indian company granting options to someone abroad, or is your Indian employee holding options in a company abroad?
Take the outbound issue first. An Indian company may issue employees' stock options to persons resident outside India who are its employees or directors, or employees or directors of its holding company, joint venture or wholly owned overseas subsidiary, under the Foreign Exchange Management (Non-debt Instruments) Rules, 2019. The scheme has to be drawn up in accordance with the Companies Act, 2013 or the applicable SEBI regulations, and the issue must stay within the sectoral cap applicable to the company. Reporting is the part that gets missed: Form ESOP is filed on the Reserve Bank's FIRMS portal within thirty days from the date of issue of the options, under the Foreign Exchange Management (Mode of Payment and Reporting of Non-Debt Instruments) Regulations, 2019.
Companies with a distributed engineering team routinely grant to a contractor in Poland or a country manager in Dubai and never file anything, because nobody told them a grant is a reportable event. But it is, and the reporting clock runs from issue of the option rather than from allotment of the share.
The inbound case is the mirror image. An Indian resident employee of the local subsidiary of a foreign parent receives the parent's stock. Acquisition of foreign securities under an employee stock option scheme is permitted under the overseas investment framework, and the employee's obligations continue after acquisition. Foreign shares held at any point during the year go into Schedule FA of the income-tax return, and the omission is not a technicality: undisclosed foreign assets sit inside the black-money regime, with penalties that dwarf the value of a small option grant. When the shares are sold, the gain is taxable in India for a resident, subject to any treaty relief, and the perquisite at exercise was taxable in India as well because the employment is here.
The two flows also collide in one place worth flagging. Where an Indian company's foreign parent grants options and the Indian entity is recharged the cost, that recharge is a cross-border payment with its own transfer-pricing and withholding questions. Neither of those belongs in the ESOP plan document, but both belong on the finance team's list before the first vest.
The listed-company overlay and the IPO runway
For an unlisted company, Rule 12 is the whole of the company-law position. So why should a company five years away from a listing care what SEBI thinks? Because from the moment a draft red herring prospectus is filed, the Securities and Exchange Board of India (Share Based Employee Benefits and Sweat Equity) Regulations, 2021 take over, and one of the two 2025 amendments to them reaches backwards into grants made a year earlier.
The first solved a real problem. Founders who had received options while they were plainly employees were being reclassified as promoters in the run-up to a listing, and the framework did not clearly permit them to keep options once that reclassification happened. The SEBI (Share Based Employee Benefits and Sweat Equity) (Amendment) Regulations, 2025, notified on 8 September 2025 following the board decision of 18 June 2025, allow such founders to retain and exercise options granted at least one year before the filing of the draft offer document, even after being designated promoters.
Read the timing condition twice. One year before the DRHP is filed. A company that starts thinking about founder options during IPO preparation has already missed it, and there is no cure. If a listing is plausible within three years, the founder-grant decision is a today decision.
The second amendment is narrower and has a date on it. The SEBI (Share Based Employee Benefits and Sweat Equity) (Second Amendment) Regulations, 2025, notified in December 2025, align the definition of "valuer" with section 247 of the Companies Act, 2013, so that sweat equity valuations move from merchant bankers to registered valuers, with effect from 2 January 2026 and a nine-month runway for assignments already under way.
Neither change touches the unlisted company directly. Both change what the unlisted company should be doing now if it expects to list, which is a distinction founders tend to collapse.
What happens to ESOPs when the company is wound up or struck off
Most ESOP articles stop at the IPO. The commoner outcome by a wide margin is that the company closes, so what happens to the pool then? Almost every plan document is silent about it.
Start with the legal position, which is unsentimental. An unexercised option is a contractual right to subscribe for shares. It is not a debt and it is not a claim on assets. When a company enters voluntary liquidation under section 59 of the Insolvency and Bankruptcy Code, 2016, the liquidator realises assets and distributes to stakeholders in the statutory order, and equity ranks last, behind every creditor and behind the employees' own wage and gratuity claims. An option holder who has not exercised is not even in that queue. A shareholder who exercised is at the back of it.
Strike off is the more likely route for a failed startup, because most of them close with nothing left to distribute. Under section 248 of the Companies Act, 2013, a company with nil assets and nil liabilities applies on Form STK-2 and is dissolved, and every option granted under the scheme dies with the company. There is no residual claim and nothing to litigate. What the process does require is that the overdue Registrar filings are brought current first, and the Board's report disclosures under Rule 12(9) are part of what has to be complete.
The question worth asking earlier, then, is what your plan says about a wind-down where there is something left. Some plans accelerate vesting on a solvent liquidation so that employees can participate in a surplus distribution. Most say nothing, which means unvested options lapse and vested options are exercisable only within the window the plan set, against shares in an entity that is about to be dissolved. That is a real decision, and the time to make it is when the scheme is drafted rather than in the board meeting that resolves to close. The full mechanics of both exits, including the compliance stack that has to clear before either route will run, are set out in the guide to winding up or closing a company in India.
One tax consequence deserves its own line. An employee who exercised, paid perquisite tax on a spread computed off a valuation from the last funding round, and then watched the company fold, has paid real tax on paper value. The loss on the shares is a capital loss, and a capital loss cannot be set off against salary income. The relief does not arrive where the tax was paid. That asymmetry is the strongest practical argument for a longer exercise window: it lets an employee wait and see before converting an option into a tax bill.
The order to do this in
Sequence is most of the difficulty here too. Why does an ESOP that looks like a six-week job take a quarter? Usually because the resolution was passed before the plan was written.
Decide the entity question first. A limited liability partnership cannot issue options at all, and converting later is expensive.
Build the hiring plan and derive the pool from it. Reserve what you will grant in the next eighteen to twenty-four months plus a buffer, not a benchmark percentage.
Settle the pool against the round. Agree explicitly whether the pool sits pre-money or post-money, and model the founder dilution before you agree the headline valuation.
Draft the scheme in full. Pool size, eligibility, vesting, exercise price mechanics, exercise window, leaver treatment, acceleration, lapse and administration, because every one of these has to be disclosed in the explanatory statement.
Check the eligibility exclusions against the actual cap table. Promoters, promoter group and directors above 10 per cent are out, unless the company is a recognised startup inside ten years of incorporation. Independent directors are out with no exception.
Pass the board resolution, then the shareholder resolution. Special resolution for a public company, ordinary resolution for a private company under the 5 June 2015 exemption notification. File Form MGT-14 within thirty days where a special resolution was passed.
Take the separate approvals Rule 12(5) requires: for grants to employees of a subsidiary, holding or associate company, and for any single grant of 1 per cent or more of issued capital in a year.
Issue grant letters that state the number of options, the exercise price, the vesting schedule, the exercise window, the leaver treatment and, in plain words, who funds the tax at exercise.
Open the Form SH-6 register and keep it current from the first grant, not from the first diligence request.
Get the valuation right at exercise. The perquisite is computed on fair market value at the exercise date, and for unlisted shares that means a valuation on or shortly before that date.
Withhold and deposit the tax, or apply the section 392(3) deferral if, and only if, the company holds the Inter-Ministerial Board certificate under section 140.
File Form PAS-3 within thirty days of each allotment, and disclose the year's option activity in the Board's report under Rule 12(9).
Steps four through seven are where the calendar actually goes, and steps nine through twelve are where the defects accumulate quietly for years. Neither set needs a full-time hire, but both need somebody who owns the file.
An option pool is a legal instrument, a payroll obligation and a tax computation at the same time, and it stays correct only if all three are maintained together. Outsource360 runs company registration and compliance including scheme documentation, resolutions and the ROC filings, with virtual CFO support for the valuation, withholding and cap-table side. Book a consultation if that is the work you would rather not carry in-house.
Frequently asked questions
What is the minimum vesting period for ESOPs in India?
One year. Rule 12(6)(a) of the Companies (Share Capital and Debentures) Rules, 2014 requires a minimum period of one year between the grant of options and their vesting. Nothing in the Act or the Rules prescribes a maximum period, a schedule shape or an exercise window, so the four-year schedule with a one-year cliff is market practice rather than law.
When is an ESOP taxed in India?
Twice. At exercise, the difference between the fair market value of the share on the exercise date and the amount the employee paid is a perquisite under section 17(1)(d) of the Income-tax Act, 2025, taxed at slab rates with the employer withholding. At sale, the difference between the sale price and that same fair market value is capital gains, with the cost of acquisition fixed by section 73. Grant and vesting are not taxable events.
Can founders and promoters hold ESOPs in an Indian startup?
Only inside a window. Rule 12 excludes promoters, the promoter group, and directors holding more than 10 per cent of outstanding equity from the definition of employee. For a startup recognised under DPIIT notification G.S.R. 127(E) dated 19 February 2019, those two exclusions do not apply for ten years from incorporation, a period extended from five years by G.S.R. 574(E) dated 16 August 2019. Independent directors are excluded with no startup carve-out.
Does a private limited company need a special resolution to issue ESOPs?
No. Section 62(1)(b) of the Companies Act, 2013 requires a special resolution, but the Ministry of Corporate Affairs exemption notification G.S.R. 464(E) dated 5 June 2015 allows a private company to pass an ordinary resolution instead. The exemption is available only to a private company that is not in default of its annual filings, so the ROC backlog has to be clear first.
How large should a startup's ESOP pool be?
Ten to fifteen per cent of fully diluted equity is the common range for an early-stage Indian startup, but the number should come from the hiring plan. Size it against the senior roles you expect to fill in the next eighteen to twenty-four months, plus top-ups for existing staff and a buffer. Unallocated pool is dilution you have paid for and are not using.
What is the sixty-month ESOP tax deferral and who qualifies?
Section 392(3) of the Income-tax Act, 2025 lets an eligible start-up defer the tax on the exercise perquisite, and section 289(3) makes it payable within fourteen days of the earliest of sixty months from the end of the relevant tax year, the sale of the shares, or the employee leaving. It is confined to an eligible start-up referred to in section 140, which requires a certificate of eligible business from the Inter-Ministerial Board. DPIIT recognition alone does not qualify.
Is the deferral forty-eight months or sixty months?
Sixty, for allotments under the current Act. The forty-eight-month figure comes from section 192(1C) of the repealed Income-tax Act, 1961, which measured the period from the end of the relevant assessment year. The Income-tax Act, 2025 works in tax years, and section 289(3) expresses the same window as sixty months from the end of the tax year.
How is the fair market value of an unlisted company's shares determined for ESOP tax?
Section 17(4)(a) of the Income-tax Act, 2025 leaves the method to be prescribed by rules. For unlisted shares the prescribed method has required a merchant banker's valuation made on the date of exercise or on a date not more than 180 days before it. Because the Income-tax Rules, 2026 replaced the 1962 Rules alongside the Act, verify the current rule reference before citing a number.
What happens to vested options when an employee resigns?
Rule 12(8) provides that options not vested on the date of resignation or termination expire immediately, and vested options may be exercised in accordance with the scheme. So the plan document decides the window. Thirty days is punitive, ninety days is the Indian market standard, and an extended window for a good leaver is increasingly common and costs the company nothing in cash.
Who pays the tax when a leaving employee exercises options?
The employee bears the tax, and the employer is obliged to withhold it under section 392 of the Income-tax Act, 2025. The practical difficulty is that the salary that would normally absorb the withholding has stopped, so the amount has to be recovered from the employee or funded from the settlement. A grant letter should state which, because the default is an unfunded demand on someone who has just left.
How are ESOP buybacks taxed in India in 2026?
As capital gains. Section 69 of the Income-tax Act, 2025, as substituted by the Finance Act, 2026 with effect from 1 April 2026, treats the difference between the cost of acquisition and the buy-back consideration as capital gains, reversing the deemed-dividend treatment that applied from 1 October 2024. Where the seller is a promoter, which for an unlisted company includes anyone holding more than 10 per cent, section 69(2) adds a further tax on top.
Can an LLP issue ESOPs?
No. A limited liability partnership has no share capital and no mechanism to issue securities to employees, so section 62(1)(b) has nothing to operate on. An LLP can be an eligible start-up for the section 140 deduction and still cannot run an option plan, which is why the entity choice has to be settled before employee equity is promised.
What compliances follow an ESOP grant?
The company files Form MGT-14 within thirty days where a special resolution was passed, maintains the Register of Employee Stock Options in Form SH-6 at its registered office, discloses the year's option activity in the Board's report under Rule 12(9), and files a return of allotment in Form PAS-3 within thirty days of allotting shares on exercise. A separate shareholder resolution is needed for grants to a subsidiary's employees and for any grant of 1 per cent or more of issued capital to one employee in a year.
Can an Indian company grant ESOPs to employees outside India?
Yes, subject to exchange control. The Foreign Exchange Management (Non-debt Instruments) Rules, 2019 permit an Indian company to issue options to non-resident employees and directors of the company or of its holding company, joint venture or wholly owned overseas subsidiary, provided the scheme complies with the Companies Act or the applicable SEBI regulations and the issue stays inside the sectoral cap. Form ESOP is filed on the FIRMS portal within thirty days of issue.
Can founders keep their ESOPs after an IPO?
Yes, if the timing was right. The SEBI (Share Based Employee Benefits and Sweat Equity) (Amendment) Regulations, 2025, notified on 8 September 2025, allow founders who are later classified as promoters to retain and exercise options granted at least one year before the draft offer document is filed. Options granted inside that one-year window do not get the benefit, and there is no way to fix it afterwards.
What happens to ESOPs if the startup shuts down?
They lapse. An unexercised option is a contractual right to subscribe, not a claim on assets, so it ranks nowhere in a liquidation, and it is extinguished when a company is dissolved on strike off under section 248 of the Companies Act, 2013. In a solvent voluntary liquidation under section 59 of the Insolvency and Bankruptcy Code, 2016, equity is paid last if anything is left. An employee who exercised and paid perquisite tax before the company failed is left with a capital loss that cannot be set off against salary income.
References
Companies Act, 2013, sections 54, 62(1)(b), 68, 117, 133 and 248, mca.gov.in.
Companies (Share Capital and Debentures) Rules, 2014, rule 12, including the Explanation to rule 12(1) on eligible employees, rule 12(2) on explanatory-statement disclosures, rule 12(3) on variation of terms, rule 12(4) on exercise price, rule 12(5) on separate resolutions, rule 12(6) on the one-year minimum vesting period, rule 12(8) on non-transferability and leaver treatment, rule 12(9) on Board's report disclosures and rule 12(10) on the Form SH-6 register, Ministry of Corporate Affairs.
Ministry of Corporate Affairs notification G.S.R. 574(E) dated 16 August 2019, the Companies (Share Capital and Debentures) Amendment Rules, 2019, extending the startup exemption in rule 12 from five years to ten years.
Ministry of Corporate Affairs exemption notification G.S.R. 464(E) dated 5 June 2015, permitting a private company to approve an employees' stock option scheme by ordinary resolution.
Department for Promotion of Industry and Internal Trade notification G.S.R. 127(E) dated 19 February 2019, the definition of "startup" applied by rule 12.
Income-tax Act, 2025 (Act No. 30 of 2025), in force 1 April 2026, section 17(1)(d) and section 17(4) definitions of "option", "specified security", "sweat equity shares" and the valuation rule in section 17(4)(h), incometaxindia.gov.in.
Income-tax Act, 2025, section 392(1) on withholding from salary and section 392(3) on the eligible start-up deferral, read with section 289(3) on the fourteen-day payment window and the sixty-month outer limit.
Income-tax Act, 2025, section 140, including the definition of "eligible start-up" in section 140(16)(b) and the turnover cap raised from one hundred crore to three hundred crore rupees by Act No. 4 of 2026 with effect from 1 April 2026.
Income-tax Act, 2025, section 73, table serial number 4, fixing the cost of acquisition of a specified security or sweat equity share at the fair market value taken into account under section 17(1)(d).
Income-tax Act, 2025, section 69 on capital gains on purchase by a company of its own shares, as substituted by Act No. 4 of 2026 with effect from 1 April 2026, including the additional tax on promoters in section 69(2) and the definition of promoter in section 69(3).
Income-tax Act, 2025, section 197(1)(b), long-term capital gains at 12.5 per cent.
Securities and Exchange Board of India (Share Based Employee Benefits and Sweat Equity) Regulations, 2021, sebi.gov.in.
Securities and Exchange Board of India (Share Based Employee Benefits and Sweat Equity) (Amendment) Regulations, 2025, notified 8 September 2025, pursuant to the board meeting of 18 June 2025, on retention of founder options granted at least one year before the draft offer document.
Securities and Exchange Board of India (Share Based Employee Benefits and Sweat Equity) (Second Amendment) Regulations, 2025, notified December 2025, aligning the definition of valuer with section 247 of the Companies Act, 2013 with effect from 2 January 2026.
Foreign Exchange Management (Non-debt Instruments) Rules, 2019 and the Foreign Exchange Management (Mode of Payment and Reporting of Non-Debt Instruments) Regulations, 2019, on issue of options to persons resident outside India and Form ESOP reporting within thirty days, rbi.org.in.
Insolvency and Bankruptcy Code, 2016, section 59, voluntary liquidation of corporate persons, ibbi.gov.in.
ESOP buyback volumes for the first quarter of 2026 and cumulative volumes since 2020 are an industry compilation of publicly announced buybacks, not an official statistic. The count of Inter-Ministerial Board certificates against DPIIT-recognised startups is likewise a compiled figure. Both are cited as market indications and should be treated as approximate.
Disclaimer
This article is for educational and general business information purposes only and does not constitute professional legal, financial, or tax advice. It states the Indian position on employee stock options as it stood on the date at the top of this page. Company-law rules, exchange-control reporting requirements, SEBI regulations and income-tax provisions change by notification, circular and amendment, and several of the instruments described here were issued or substituted during 2025 and 2026. Three points are flagged as unsettled or fast-moving and should be checked in their current form before anything is filed or granted: the rule reference and prescribed valuation method for the exercise-date fair market value under the Income-tax Rules, 2026, which replaced the Income-tax Rules, 1962 alongside the Act; the buy-back position under section 69 of the Income-tax Act, 2025 as substituted with effect from 1 April 2026, which is the third treatment applied to buy-backs in three years; and the availability of the Inter-Ministerial Board certificate that gates the section 392(3) deferral, which is decided case by case. Market figures for pool sizes, exercise windows and buyback volumes are observations, not statutory amounts. Any provision, form, deadline or rate that decides a filing should be verified against the current text on the MCA, CBDT, SEBI and RBI portals. Consult a qualified lawyer, company secretary or chartered accountant before acting on anything set out here.
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