ESOP for Startups in India

Employee Stock Option Plans (ESOPs) are becoming an essential part of India’s startup culture. They allow startups to offer equity to employees as a reward for their contribution and loyalty. In an ecosystem where financial resources are often tight, ESOPs help attract and retain top talent by offering long-term wealth creation opportunities. For employees, it’s a chance to own a part of the company they help build. For founders, it's a way to drive performance and align the team with the company’s vision. As the Indian startup scene matures, ESOPs are now a smart strategy for sustainable and scalable growth.

What is ESOP?

An Employee Stock Option Plan (ESOP) is a benefit scheme where companies offer employees the right to purchase shares at a predetermined price after a certain period. Commonly used by startups, ESOPs serve as a tool to attract, retain, and motivate talent by giving them ownership in the company’s growth. Instead of immediate stock ownership, employees earn the right over time through a vesting schedule. When exercised, they can buy shares often below market value. ESOPs align employee interests with the company’s long-term goals, promote loyalty, and conserve cash, making them an effective strategy for startup success in competitive markets.

How Does ESOP Work in Startups?

ESOPs (Employee Stock Ownership Plans) are a popular tool used by startups to attract, retain, and motivate employees by offering them an ownership stake in the company. Here's a breakdown of how ESOPs typically work in startups:

Setting Up an ESOP Trust 

• Stock Allocation: The company allocates a specific number of shares to the ESOP trust for distribution among employees.

• Trust Formation: A trust is established to manage the allocated shares, ensuring transparency and proper administration.

• Employee Participation: Employees become eligible for ESOPs, and their participation is based on the terms set by the company, such as tenure and performance conditions. Employees gradually acquire ownership of the shares over time, usually through vesting schedules. 

Acquiring Shares 

• Vesting Schedule: A structured timeline that determines when an employee gains ownership of granted shares.

• Gradual Ownership: Shares are allocated over time, typically based on continuous employment or performance goals. 

Benefitting from Share Growth 

• Value Appreciation refers to the increase in the value of an asset, such as company shares, over time due to factors like business growth, market demand, or economic conditions.

• Employee Gains refer to the financial benefits employees receive from equity compensation plans, including stock options, restricted stock units (RSUs), or performance-based incentives. These gains allow employees to share in the company’s success through increased stock value. 

Aligning Interests 

• Mutual Success: Achieving shared goals through collaboration and support, where all parties contribute and benefit equally.

• Motivation: The internal drive to achieve goals, fueled by personal or external factors, pushing individuals to take action and maintain persistence towards their objectives. 

ESOPs Under Company Law

Under Indian company law, Employee Stock Option Plans (ESOPs) are regulated to ensure fairness, transparency, and adherence to statutory requirements. Here’s an overview of the legal framework governing ESOPs for Indian startups:

Eligibility for ESOPs 

• Eligible Participants: Employees, officers, and directors of the company, including those of its subsidiaries or holding companies, are eligible to receive ESOPs.

• Subscription Rights: These individuals are granted the option to subscribe to the company’s shares at a pre-agreed price at a future date. 

Applicability to Companies 

• Private Limited Companies: Can issue ESOPs under the Companies Act, 2013. Must follow prescribed rules and board/shareholder approvals.

• Listed Companies: Governed by SEBI (SBEB & SE) Regulations. Stricter disclosure, compliance, and reporting norms. 

ESOP Features 

• Discounted Share Price: Employees can buy shares at a price lower than the market value.

• Conversion to Shares: Options granted convert into actual equity shares after vesting and exercise.

• Salary Deduction: Some companies allow ESOP purchase through monthly salary deductions, making it easier for employees to invest. 

Implementation Process 

• Feasibility Study: Assess the financial and strategic viability of introducing an ESOP.

• Drafting & Shareholder Approval: If feasible, draft the ESOP policy and seek approval from shareholders through a resolution.

• Letter of Grant: Issue a formal Letter of Grant to eligible employees, detailing terms, number of options, and conditions.

• Vesting Period: Employees must complete the vesting period before they can exercise options and convert them into company shares. 

Legal Documents Required for Startup ESOPs 

• Stock Option Agreements: A legal contract granting employees the right to buy company shares at a fixed price in the future.

• Vesting Schedules: Documents outlining the timeline and conditions under which employees earn ownership of their options.

• Plan Rules and Guidelines: Detailed rules covering eligibility, exercise price, option terms, and overall plan management.

• Board Resolutions: Official approvals by the board of directors to adopt and implement the ESOP.

• Employee Communication Materials: Clear explanations provided to employees about the ESOP’s benefits, structure, and procedures. 

Quick Tips for Opting for ESOPs

When evaluating ESOPs as part of your compensation, it’s essential to take a strategic and informed approach especially when dealing with startups or listed companies, where terms and risks can vary significantly.

Below is a practical guide to help you assess and make the most of ESOP offers:

Evaluate the Start-Up Risk 

• Understand the Company’s Growth Potential: Startup ESOPs are tied to company success. Assess business model, market position, and funding status.

• Vesting Period and Lock-In: Commonly 3–4 years vesting, with 12–18 months lock-in after allotment. Ensure you're comfortable with the timeline. 

Ensure Proper Documentation 

• Accurate Share Valuation: Confirm how share value is calculated to understand potential financial gains.

• Exit Mechanisms: Look for defined exit options (e.g., promoter buyback) in case the company doesn’t go public. 

Listed Company Considerations 

• Favorable Vesting and Lock-In Terms: Prefer shorter vesting periods and no lock-in to retain flexibility.

• Thorough Review of Terms: Request the ESOP scheme brochure and review terms like exercise price and FMV computation.

• TDS Deductions: Ensure clarity on tax deductions (TDS) as it impacts your net proceeds. 

Strategic Actions and Negotiations 

• Negotiate Key Terms: Key employees can push for better terms: lower exercise price, faster vesting, or increased grant size.

• Set Expiry Reminders: Track ESOP expiry dates to avoid losing the right to exercise options.

• Consult a Financial Planner: A financial advisor can help optimize when and how to exercise or sell your shares. 

Cost of ESOPs and Distributions 

• Administrative Costs: These are the costs associated with managing the ESOP program, including legal, compliance, and administrative tasks. It may also involve software systems for tracking options, shareholder communication, and reporting.

• Valuation Costs: The company incurs costs for hiring external professionals to determine the value of shares, especially in private companies. This is crucial for setting the exercise price and ensuring accurate share valuation for employees.

• Potential Dilution: When ESOPs are exercised, it increases the total number of shares outstanding, leading to dilution of existing shareholders' equity. This could affect control and the value of shares for current investors. 

Distributions From the ESOP 

• Tax Implications: Employees may face taxes on the difference between exercise and sale price, including capital gains and other potential taxes.

• Cash Flow Considerations: Companies need to ensure sufficient liquidity for share buybacks or distributions, as poor cash flow can affect both company finances and employee options. 

ESOP Taxation for Employees

Taxability of ESOPs:

• Perquisite Tax: The difference between the exercise price and the fair market value of the shares at exercise is taxable as a perquisite (additional income) for the employee. Exemptions or deductions may apply based on specific circumstances or tax laws.

• Taxable Event: Employees are generally taxed when they exercise their options, but the exact timing and method of taxation may vary based on company policies and local tax laws.

Calculation of Taxable Value 

• Perquisite Value: This is the taxable amount added to the employee’s income. It is calculated as the difference between the Fair Market Value (FMV) of the share on the exercise date and the exercise price paid by the employee.

• Fair Market Value (FMV): The FMV is the value of the company’s share on the date the ESOP is exercised. For listed companies, it’s the market price; for unlisted companies, it’s determined by a registered valuer.

• Exercise Price: This is the price at which the employee is allowed to buy the shares under the ESOP. It is usually lower than the FMV and is fixed at the time of grant. 

Capital Gains Tax

Short-Term vs. Long-Term:

The holding period after exercising ESOPs determines the type of capital gain. 

• Short-Term Capital Gains (STCG): If shares are sold within 12 months (listed) or 24/36 months (unlisted), gains are considered short-term.

• Long-Term Capital Gains (LTCG): Applies when shares are held beyond this period. 

Tax Rates: 

• STCG: Typically taxed at 15% (for listed shares); higher rates may apply to unlisted shares based on income slab.

• LTCG: 10% for gains over Rs.1 lakh (listed); 20% with indexation for unlisted shares. Rates may vary by jurisdiction. 

Example of ESOP Calculation

Calculation of ESOP: 

• Grant:

  An employee is granted 1,000 ESOPs at an exercise price of Rs.50.

• At Exercise:

  The Fair Market Value (FMV) on the exercise date is Rs.120.

• Perquisite Value (Taxable):

  Rs.120 (FMV) – Rs.50 (Exercise Price) = Rs.70 per share

  Total Taxable Value: 1,000 × Rs.70 = Rs.70,000

• At Sale:

  If sold at Rs.150 after a year, Capital Gain = Rs.150 – Rs.120 = Rs.30 per share

  Total Capital Gains: 1,000 × Rs.30 = Rs.30,000 

Factors Influencing ESOP Calculation and Allocation: 

• Role and Seniority: Senior employees receive more ESOPs due to their strategic roles, leadership impact, and greater responsibility within the organization.

• Company Valuation: A higher valuation reduces the number of shares needed for desired value, impacting both allocation size and exercise price.

• Performance Metrics: ESOPs may be linked to individual or company performance, rewarding employees who contribute significantly to business goals and outcomes.

• Vesting Period: Determines when employees can exercise options, influencing retention and the timing of ownership benefits.

• Dilution Strategy: Companies control ESOP allocation to protect shareholder value and avoid excessive dilution of existing equity. 

Benefits of ESOP for Startups 

• Talent Acquisition & Retention: ESOPs attract top talent by offering ownership stakes, and they help retain employees through long-term incentives like vesting periods.

• Alignment of Interests: Employees become stakeholders, aligning their goals with the company’s growth and success.

• Motivation & Engagement: Ownership encourages employees to work harder and stay committed, knowing their efforts directly impact the company's value.

• Culture Building: ESOPs promote a sense of ownership and shared responsibility, strengthening company culture and team spirit.

• Tax Benefits: Startups and employees may enjoy tax advantages depending on the jurisdiction and ESOP structure.

• Exit Strategy: ESOPs offer liquidity to employees and can be part of the startup’s broader exit or buyback plan. 

Benefits of ESOP for Employees 

• Ownership Stake: Employees gain a direct stake in the company, giving them a sense of ownership and a share in its success.

• Capital Appreciation: As the company grows, the value of ESOP shares can increase, offering employees the potential for significant wealth creation.

• Retirement Savings: ESOPs can serve as an additional retirement asset, especially when shares are held long-term and sold at higher valuations.

• Tax Advantages: Depending on the jurisdiction, employees may benefit from tax deferrals or lower tax rates on gains from ESOPs. 

Non-Financial Benefits 

• Enhanced Engagement: Knowing they have a stake in the company, employees are more likely to be committed, productive, and actively involved in business outcomes.

• Career Development: ESOPs often come with clearer growth paths and performance-linked rewards, encouraging employees to invest in their professional development.

• Sense of Ownership: ESOPs instill a feeling of being part of the company’s journey, fostering loyalty, accountability, and a stronger emotional connection to organizational success. 

Disadvantages of ESOPs for Startups

ESOPs offer many benefits, but they can also present challenges for startups: 

• Complexity and Administrative Burden: Setting up and managing an ESOP involves legal, regulatory, and compliance complexities that require expert support and ongoing administration.

• Dilution of Ownership: Granting shares to employees dilutes the equity of existing founders and investors, potentially impacting control and decision-making power.

• Financial Challenges: Funding share buybacks or managing tax liabilities from exercised options can strain startup cash flow, especially during early growth stages.

• Vesting and Share Value Fluctuations: Long vesting periods may reduce immediate employee benefit, while share value volatility can affect perceived and actual ESOP value. 

What Will Happen to ESOPs When the Company Is Listed? 

• IPO & Liquidity: When a company goes public, ESOPs become liquid, meaning employees can sell their shares on the open market, providing a clear exit strategy and immediate cash flow options.

• Vesting Matters: Employees must complete the vesting period before they can exercise their options. Post-IPO, the vesting period may remain, but the shares become easier to sell once vested.

• Exercising Options (if applicable): Employees can exercise their options after vesting and purchase shares at the predetermined exercise price. They may then sell on the stock exchange if desired.

• Potential for Gains: As the company goes public, the value of ESOPs could increase significantly, offering employees the potential for substantial financial gains based on the company’s market performance. 

Conclusion

ESOPs are a valuable tool for startups in India, helping attract, retain, and motivate talent by offering employees ownership in the company. They align employee interests with business growth, fostering commitment and engagement. ESOPs provide both financial benefits, like capital appreciation and tax advantages, and non-financial ones, such as career development. However, startups must manage the complexity, potential dilution of ownership, and financial challenges. With careful implementation, ESOPs can drive long-term value and growth, benefiting both employees and the company, especially when the startup grows or goes public.

If you have any queries regarding ESOP for Startups, then you can connect with Compliance Calendar LLP experts through email info@ccoffice.in or Call/Whatsapp at +91 9988424211.

FAQs

Q1. Can startups give ESOPs?

Ans. Yes, startups can offer ESOPs to attract and retain talent, providing employees with ownership stakes. This aligns their interests with the company’s success, fostering commitment and long-term growth.

Q2. What is the ESOP 30% rule?

Ans. The ESOP 30% rule refers to the guideline that a company can allocate up to 30% of its total equity to an ESOP pool, ensuring proper balance and preventing excessive dilution.

Q3. Who is not eligible for ESOP?

Ans. Individuals generally not eligible for ESOPs include independent contractors, temporary workers, non-full-time employees, non-executive directors (depending on company policy), and employees in jurisdictions with conflicting tax regulations.

Q4. Is ESOP deducted from salary?

Ans. ESOPs are not directly deducted from salary. However, employees may need to pay for the shares at the exercise price, which is separate from regular salary deductions, typically at the time of exercise.

Q5. What happens to ESOP if you quit?

Ans. If you quit, unvested ESOPs are usually forfeited. Vested ESOPs can be exercised within a specified period, often 90 days, but may be subject to company policies and share buyback options.