AS | Ankit Sarawagi|Founder, CFOmatrix·June 2026·10 min read | Updated Jun 2026 |
- An ESOP gives the right to buy shares at a fixed price after vesting. The employee is not a shareholder until the option is exercised.
- India taxes ESOPs at two stages: exercise (perquisite, taxed as salary) and sale (capital gains, listed vs. unlisted rules differ).
- Budget 2024 raised LTCG on listed equity to 12.5% and STCG to 20%. The buyback tax under Section 115QA was removed.
- Typical ESOP pool benchmarks range from 5-8% at Pre-Seed to 15-20% at Series B+. Under-sizing is a common and costly mistake.
- The Post-Termination Exercise Window (PTEW) matters enormously. Check whether it is 30 days or 3 years before accepting any offer.
- Most pre-IPO companies switch from Direct Allotment to a Trust Model 12-24 months before an IPO to clean up the cap table.
| Rs 2,100 Cr ESOP liquidity distributed to Indian startup employees in FY 2024-25 | 2 Stages ESOP tax incidence in India: at exercise and at sale | 500+ Swiggy employees estimated to become millionaires from the 2024 IPO |
What Is an ESOP?
An Employee Share Ownership Plan (ESOP) provides the right to an employee to purchase company shares at a predetermined price following a vesting period. In India, ESOPs are regulated primarily under Section 62(1)(b) of the Companies Act 2013.
This distinction is critical: the employee receives an option, not shares. Only when the employee exercises the option does the employee become a shareholder. All downstream issues, including taxation, ownership rights, voting rights, and liquidity, are linked to this exercise event.
The term ESOP in India is often used as a catch-all, but it encompasses several distinct structures:
- Stock Options (ESOPs): Right to buy shares at a fixed strike price after vesting
- Restricted Stock Units (RSUs): Shares that vest over time, no purchase price required
- Employee Stock Purchase Schemes (ESPS/ESPP): Discounted share purchase programs
- Stock Appreciation Rights (SARs): Cash or equity payout equal to share price appreciation
- Phantom Stock: Cash-settled, no actual share ownership, common for advisors and consultants
The regulatory framework differs by company type. For listed companies, SEBI SBEB Regulations 2021 apply. For unlisted companies, Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014 governs the scheme.
Consultants and advisors cannot receive ESOPs under Rule 12. Only permanent employees and eligible directors qualify. For advisors, phantom stock is the standard instrument, providing economic participation without creating actual shareholding.
Why Companies Offer ESOPs
A well-structured ESOP addresses four fundamental problems for early-stage and growth-stage companies simultaneously.
Cash Preservation
Recruiting senior talent is expensive. A startup that cannot afford a Rs 70 to 80 lakh cash package can bridge the gap with a lower cash component plus meaningful ESOP benefits. This extends runway without sacrificing the quality of hire, and often increases total compensation for the employee relative to what the market offers in pure cash.
Retention
Most ESOP schemes vest over four years with a one-year cliff. An employee who leaves before the cliff forfeits all options. After the cliff, unvested options continue to be earned monthly or quarterly. This structure creates a powerful incentive to stay through critical growth milestones, which is precisely when companies need continuity most.
Incentive Alignment
Ownership changes mindsets. Once employees hold an economic stake in the business, the conversation shifts from “what is my monthly salary” to “how does my work increase the value of this company.” This transition is particularly valuable in a startup environment where discretionary effort, initiative, and long-term thinking matter more than narrow job execution.
Governance Structure
A clearly defined ESOP scheme provides a documented framework for granting, vesting, lapsing, and forfeiting options. This matters significantly during investor due diligence. Founders who cannot cleanly explain their equity structure, including the ESOP pool, can create concern among Series A and later-stage investors. Clarity here builds trust; ambiguity costs valuation.
ESOP Structures: Direct Allotment vs. Trust Model
Indian startups use two primary models to administer their ESOP programs. Understanding the difference matters for both founders planning their equity architecture and employees trying to understand their rights.
Direct Allotment Model
This is the standard structure for early-stage startups. When an employee exercises their options, the company directly issues shares to that employee. The advantages are low setup cost, straightforward administration, and quick execution.
The disadvantage surfaces over time. As more employees exercise options across multiple grant cohorts, the cap table fills with many individual small shareholders. This complicates investor approvals, consent collection for board resolutions, and becomes particularly cumbersome during IPO processes where clean cap tables are a prerequisite.
Trust Model
Larger startups, particularly pre-IPO companies, use an employee welfare trust that holds shares on behalf of all employees. The trust consolidates ESOP-related equity into one entry on the cap table, making governance dramatically simpler.
The trust is empowered to subscribe to new shares, hold the unallocated ESOP pool, recycle forfeited grants, and manage liquidity or buyback processes. Under SEBI SBEB Regulations 2021, key constraints apply:
- Maximum annual buyback through the trust: 2% of paid-up share capital
- Maximum equity held by the ESOP trust: 5% of paid-up share capital
- Promoters and Key Managerial Personnel (KMPs) cannot serve as trustees
- Shares held through the trust do not carry voting rights
Most companies switch from the Direct Allotment Model to the Trust Model approximately 12 to 24 months before an IPO. If your company is at that stage, understanding the implications of the trust structure on your voting rights and liquidity windows is important before your options vest.
How ESOPs Work: Step-by-Step
On paper it appears complex. Operationally it follows a defined workflow with six stages, each with its own legal and financial implications.
Board Approval
The Board of Directors must approve: the size of the ESOP pool, the terms of the scheme, the valuation framework used to determine FMV, and employee eligibility criteria. This creates the legal foundation for the program.
Shareholder Approval
Section 62(1)(b) of the Companies Act 2013 requires a Special Resolution: a 75% shareholder vote. This ensures majority shareholder buy-in before any dilution occurs. For subsequent top-ups to the ESOP pool, fresh shareholder approval is needed each time.
Grant Letters Issued
Each employee receives a grant letter specifying: the number of options granted, the strike price (exercise price), the vesting schedule, conditions for exercising options, and exit-related conditions including good-leaver and bad-leaver scenarios.
Vesting Period
Standard vesting in Indian startups: four-year vesting period with a one-year cliff, followed by monthly or quarterly vesting. An employee who leaves before the cliff forfeits all options. Post-cliff, unvested options are forfeited on exit, while vested options are subject to the PTEW.
Exercise
Once vested, the employee can exercise options by paying the strike price to the company. The company then issues shares. This is the moment perquisite taxation triggers. The FMV at exercise minus the strike price is taxable as salary income in the year of exercise.
For unlisted companies, the FMV must be certified by a SEBI-registered Category I Merchant Banker. A Chartered Accountant valuation does not satisfy this requirement under the Income Tax Rules. Using an incorrect valuation basis can create significant tax disputes during assessment.
Liquidity Event
The employee converts paper wealth into real money only at a liquidity event: an IPO, a company-initiated buyback, a secondary sale to a new investor, or an acquisition. Until one of these events occurs, the shares are effectively illiquid. This is the lesson many startup employees learned during the 2022-23 funding winter.
ESOP Taxation in India
The tax treatment of ESOPs in India involves two distinct stages. Most employees understand neither fully until it is too late to plan around them.
Stage 1: Tax at Exercise (Perquisite Tax)
When an employee exercises their options, the spread between the Fair Market Value (FMV) and the strike price is treated as a perquisite under Section 17(2)(vi) of the Income Tax Act. This amount is added to salary income and taxed at the applicable slab rate in the year of exercise.
For example: if the strike price is Rs 10 and FMV at exercise is Rs 100, the perquisite value is Rs 90 per share. If the employee exercises 1,000 shares, Rs 90,000 is added to salary income and taxed accordingly. The company is required to deduct TDS on this amount.
Stage 2: Capital Gains Tax at Sale
When the employee subsequently sells the shares, capital gains tax applies on the difference between the sale price and the FMV at exercise (the FMV at exercise becomes the cost of acquisition for capital gains purposes).
| Share Type | Short-Term Holding | Long-Term Holding | LTCG Rate | STCG Rate |
|---|---|---|---|---|
| Listed Equity | Up to 12 months | More than 12 months | 12.5% above Rs 1.25 lakh exemption | 20% |
| Unlisted Equity | Up to 24 months | More than 24 months | 12.5% without indexation | Applicable slab rate |
Post-Budget 2024 update: The Finance (No. 2) Act 2024 raised LTCG on listed equity from 10% to 12.5% and STCG from 15% to 20%. It also removed the buyback tax under Section 115QA at the company level. This last change has significantly reshaped how startups plan secondary liquidity for employees, with many switching from structured buybacks to secondary sales.
Why ESOP Can Beat Cash: The Math
Consider a simplified comparison. An employee receives either a Rs 10 lakh cash bonus or Rs 10 lakh worth of ESOPs granted at FMV equal to strike price (so no immediate tax at grant).
The cash bonus is taxed immediately at slab rate. At 30%, the employee nets Rs 7 lakh. That Rs 7 lakh then grows at whatever investment return the individual achieves independently.
With the ESOP: if the FMV at exercise rises to Rs 30 lakh and the employee subsequently sells at Rs 45 lakh, the tax picture is: (i) perquisite tax on Rs 20 lakh at exercise, and (ii) LTCG on the appreciation post-exercise. Even after both tax stages, the net wealth generated can substantially exceed the Rs 7 lakh cash scenario if the company grows significantly.
This is the fundamental ESOP proposition: non-linear upside tied to company value creation. The downside is equally sharp. If the company’s valuation drops below the strike price, the options are underwater and worthless. Byju’s employees experienced this at scale.
“The ESOP pool as an institution is no longer just a recruitment mechanism in India. It now influences fundraising, governance, retention, dilution, taxation, and long-term wealth creation simultaneously. Companies that manage it well retain employees and attract investor trust. Those that treat equity capriciously lose both.”
ESOP Pool Sizing Strategy
There is one recurring problem in the startup world: companies either under-size their ESOP pool or grant too generously too early. Both are costly mistakes with long-term consequences.
Typical ESOP Pool Benchmarks by Stage
| Startup Stage | Typical Pool Size |
|---|---|
| Pre-Seed | 5% to 8% |
| Seed | 10% to 12% |
| Series A | 12% to 15% |
| Series B and beyond | 15% to 20% |
Indian startups tend to under-size their pools relative to US counterparts. This creates hiring problems later when bringing on VP-level and C-suite talent who expect meaningful equity, but the remaining pool is too small to make credible offers.
Pre-Money vs. Post-Money Dilution
This nuance is more consequential than most founders realise. Investors almost always request that the ESOP pool be created before the investment closes. This means founders absorb the dilution from the ESOP pool top-up, not the new investors. Over multiple funding rounds, poor ESOP pool planning can heavily erode founder holdings.
A practical approach: estimate the pool needed for the next 18 to 24 months of planned hires, then negotiate for smaller, sequential replenishments rather than a large one-time dilution. Transparency with investors about the hiring plan builds the trust needed to negotiate these terms effectively.
Essential ESOP Design Decisions
The quality of ESOP design, not the existence of an ESOP program, determines whether it achieves its goals. The following decisions shape both the legal robustness and the motivational effectiveness of a scheme.
Broad-Based vs. Senior-Only Granting
A growing number of Indian startups are extending ESOPs beyond senior leadership to broader team levels. Broad-based granting improves ownership culture and retention across the organisation, but it requires more administrative infrastructure and consumes the pool faster. The choice should be driven by company stage and the role equity plays in the overall compensation philosophy.
Vesting Schedule Design
The four-year cliff-plus-monthly structure remains the market standard. However, there is a growing shift toward linear annual vesting (25% per year) rather than back-ended schedules that concentrate most vesting in later years. Linear vesting aligns employee reward more closely with time contribution and reduces early-exit regret.
Post-Termination Exercise Window (PTEW)
The PTEW is one of the most consequential and most poorly understood ESOP design variables. The conventional approach gave employees only 30 to 90 days after exit to exercise vested options. This creates severe financial pressure: the employee must either pay the strike price and the resulting tax bill immediately, or forfeit valuable options.
Companies including Razorpay, CRED, and Zomato have expanded their PTEW to three to four years. This dramatically improves employee trust and reduces the perverse incentive to stay at a company simply to avoid forfeiting options. A long PTEW is increasingly seen as a proxy for employee-friendly equity culture.
Liquidity Cadence
Without a path to liquidity, options are primarily a psychological benefit rather than a financial one. Companies that run structured buyback programs every 18 to 24 months create a tangible connection between equity ownership and actual wealth. Employees at companies with liquidity programs value their options materially differently from those at companies with no liquidity history.
ESOP vs. RSU vs. SAR vs. Phantom Stock
These instruments all provide economic participation in company value creation, but they work differently in structure, taxation, and dilution impact. Understanding the distinctions matters when evaluating an offer letter or designing a compensation framework.
| Instrument | Exercise Price | Tax Trigger | Dilutive | Common Usage |
|---|---|---|---|---|
| ESOP | Yes | Exercise + sale | Yes | Indian startups (standard) |
| RSU | No | Vesting | Yes | Listed companies, MNCs |
| ESPS/ESPP | Discounted | Purchase + sale | Yes | MNCs with Indian subsidiaries |
| SAR | No | Payout | Sometimes | Dilution management |
| Phantom Stock | No | Cash payout | No | Advisors, consultants |
India’s Notable ESOP Liquidity Events
Indian startups have demonstrated that ESOP wealth creation is real and substantial when companies reach scale:
- Flipkart: Over $1.4 billion in ESOP liquidity distributed since 2018 across multiple funding rounds
- Nykaa: The IPO generated hundreds of crores of employee wealth across grant cohorts
- Paytm: The IPO reportedly produced approximately 350 crorepati employees
- Swiggy: The 2024 IPO is one of the largest ESOP wealth events in India to date, with an estimated 500 employees becoming millionaires
These outcomes reflect a shift in the Indian startup ecosystem: employees now actively seek and expect ESOP liquidity pathways, not just grant letters.
Common ESOP Mistakes Companies Make
Wrong Strike Price
Some startups link the strike price to the preferred share valuation, a value employees can rarely achieve economically given liquidation preferences. Others skip a formal valuation framework entirely. Both approaches create tax risk and governance exposure that surfaces during due diligence or audits.
Short PTEW Windows
A 30-day post-termination exercise window on illiquid equity creates anxiety, not culture. Employees who cannot afford to exercise and pay tax simultaneously are forced to forfeit options they legitimately earned. This breeds resentment and reduces the perceived value of equity compensation across the entire workforce.
Absence of Liquidity Planning
Companies that grant ESOPs without any plan for structured liquidity events remove the primary financial motivator from the equation. Employees who cannot see a realistic path to realising value will mentally discount their equity to near zero, undermining the entire program’s retention objective.
Over-Allocation to Early Employees
Granting away large portions of the pool before achieving product-market fit leaves insufficient equity for later senior hires when the company actually needs institutional-quality leadership. This is a sequencing problem that cannot be corrected without painful dilution later.
Lack of Communication
Most employees receiving ESOP grants do not clearly understand: their actual percentage ownership on a fully diluted basis, how dilution works across funding rounds, the tax consequences of exercise, the mechanics of the exercise process, or when and how a liquidity event might occur. This knowledge gap breeds distrust and reduces the motivational value of equity to near zero for employees who feel confused or misled.
A flowery grant letter can be of very little importance if the operational specifics behind it are undefined. Before issuing grants, ensure the scheme document covers every scenario: exercise mechanics, buyback procedures, PTEW, good-leaver and bad-leaver definitions, acceleration triggers, and anti-dilution provisions. Employees who read the full document should come away with more confidence, not more questions.
Employee Evaluation Checklist: Before Accepting an ESOP Offer
When evaluating an ESOP component in any offer letter, ask the following questions before signing:
| Question | Why It Matters |
|---|---|
| What is my fully diluted equity percentage? | Number of options means nothing without context of total share count |
| What is the current company valuation? | Establishes the implied current value of the grant |
| How does the strike price compare to FMV? | Determines whether there is in-the-money value at grant |
| What is the vesting schedule and cliff? | Sets the timeline for earning equity |
| What is the Post-Termination Exercise Window? | Determines how long you have to exercise after leaving |
| Has the company run buybacks before? | Signals intent and ability to provide liquidity pre-IPO |
| Is cashless exercise permitted? | Reduces the upfront cash required to exercise |
| What happens in an acquisition or IPO? | Change of control provisions determine whether options accelerate or lapse |
| What are the good-leaver and bad-leaver definitions? | Affects whether vested options survive a resignation or termination |
Red Flags to Watch
Do not ignore these in any ESOP scheme document:
- A 30-day PTEW on illiquid private company equity
- Non-specified or ambiguous forfeiture rules
- Unbounded board discretion over grant or cancellation decisions
- No acceleration clause on change of control
- Ambiguous strike price language or no formal valuation framework
- No liquidity history and no stated liquidity roadmap
Recent Indian ESOP Regulatory Changes
The 2024-25 regulatory cycle brought significant changes to ESOP economics in India. Both Budget 2024 and SEBI SBEB amendments affect how founders design programs and how employees should plan around them.
Budget 2024: Key Changes
| Change | Impact |
|---|---|
| LTCG on listed equity raised to 12.5% | Higher tax on gains from listed shares post-IPO or secondary sale |
| STCG on listed equity raised to 20% | Discourages early sale post-exercise; rewards longer holding |
| Holding periods standardised | Clarifies LTCG vs. STCG boundary across share categories |
| Buyback tax under Section 115QA removed | Shifted tax liability from company to shareholders; reshaped startup liquidity structures toward secondary sales |
SEBI SBEB Regulation Changes
SEBI revised its rules around founder-promoter ESOP eligibility. Promoters who qualify as “promoters” for IPO classification purposes are now eligible to hold and exercise ESOPs they were allotted under certain conditions. This addressed a longstanding issue for Indian startups where founders faced ambiguity about their existing equity grants as they approached the public markets.
The removal of the buyback tax under Section 115QA has a second-order effect. With the tax now on the shareholder rather than the company, employees receiving buyback proceeds face individual tax obligations they may not have anticipated. If your company plans a structured buyback, model your post-tax realisation before committing to exercise.
Need help structuring or auditing your ESOP scheme? CFOmatrix works with Indian startups and growth-stage companies to design ESOP frameworks that are investor-ready, tax-efficient, and employee-friendly. From pool sizing to trust structure to PTEW design. | Talk to CFOmatrix |
Frequently Asked Questions
What is an Employee Share Ownership Plan (ESOP)?
An ESOP is an offer for employees to buy shares at a set price after a vesting period. Employees are not shareholders until the options they are entitled to are exercised. In India, ESOPs are primarily regulated under Section 62(1)(b) of the Companies Act 2013. The instrument may also encompass RSUs, ESPS, SARs, and phantom stock, each with different tax and ownership implications.
What are the tax implications of ESOPs in India?
Taxation occurs in two stages. At exercise: the difference between FMV and strike price is taxed as salary income (perquisite under Section 17(2)(vi)), with TDS deducted by the employer. At sale: capital gains tax applies based on whether shares are listed or unlisted and how long they were held. After Budget 2024, LTCG on listed equity is 12.5% (above Rs 1.25 lakh) and STCG is 20%. For unlisted equity, LTCG is 12.5% without indexation and STCG is taxed at applicable slab rates.
What happens to ESOPs if an employee quits?
Unvested ESOPs are normally forfeited when the employee leaves. Vested ESOPs may be exercisable for a limited period following termination, known as the Post-Termination Exercise Window (PTEW). This window varies significantly: some companies allow only 30 days, while others like Razorpay and CRED allow three to four years. Always read the ESOP scheme document carefully before deciding to leave.
How do employees make money from ESOPs?
Employees realise value from ESOPs at a liquidity event: an IPO, a company-initiated buyback, a secondary sale to a new investor, or an acquisition. Until one of these events occurs, the shares are illiquid. The gain is the difference between the sale value of the share and the strike price paid at exercise, minus any applicable taxes at both stages.
What factors should an employee consider before accepting an ESOP offer?
Employees should consider: fully diluted equity percentage, current company valuation, strike price relative to FMV, vesting schedule and cliff structure, PTEW length, whether cashless exercise is available, past buyback history, planned liquidity events, acceleration provisions on acquisition, and good-leaver versus bad-leaver definitions. A grant letter without clear answers to these questions should prompt direct questions to the company before signing.
What is the difference between the Direct Allotment Model and the Trust Model for ESOPs?
In the Direct Allotment Model, the company issues shares directly to employees on exercise. This is simpler to set up but creates many small shareholders on the cap table over time. In the Trust Model, an employee welfare trust holds shares on behalf of all employees, keeping the cap table cleaner. Under SEBI SBEB 2021, the trust is capped at 5% of paid-up share capital and an annual buyback limit of 2%. Most companies switch to the Trust Model 12 to 24 months before an IPO.
How large should an ESOP pool be at each funding stage?
Typical benchmarks: Pre-Seed 5 to 8%, Seed 10 to 12%, Series A 12 to 15%, Series B and beyond 15 to 20%. Indian startups tend to under-size pools relative to US companies. A practical rule: estimate the hiring needs for the next 18 to 24 months and size the pool accordingly, then negotiate sequential replenishments with investors rather than a single large dilution upfront.
What changed for ESOPs in Budget 2024?
Budget 2024 increased LTCG on listed equity to 12.5% (above Rs 1.25 lakh exemption) and STCG to 20%. It standardised holding periods across share categories. Critically, it removed the buyback tax at the company level under Section 115QA, shifting tax liability to shareholders on buyback proceeds. This has reshaped startup liquidity planning, with many companies moving toward secondary sales rather than structured buybacks.
AS | Founder, CFOmatrix | Finance Strategy & Equity Compliance Ankit Sarawagi has spent over a decade building, scaling, and cleaning up finance functions across startups and growth-stage companies, including 200+ D2C and consumer brands. He runs CFOmatrix, a fractional CFO practice focused on Indian D2C and growth-stage businesses. |