ESOP
What ESOP means, how it works, a worked example, the mistakes we see and the questions founders ask.
DefinitionAn Employee Stock Option Plan (ESOP) gives employees the right to buy company shares at a fixed price after a vesting period, so they share in the value they help create.
Only companies can grant ESOPs, not LLPs. The company sets aside a pool, typically 5% to 15% of equity, adopts a scheme by special resolution, files MGT-14, and issues grant letters that state the number of options, exercise price, vesting schedule and exercise window. Options vest over time, commonly four years with a one-year cliff, and the employee buys the shares by paying the exercise price. You meet ESOPs when hiring senior people below market salary, in every funding round where investors expect a pool, and at exit when options are cashed out. What it means for you: tax is due on exercise as a salary perquisite on the difference between fair value and exercise price, deferred for eligible DPIIT startups, and again as capital gains on sale.
How ESOP works
A company adopts an ESOP scheme under Section 62(1)(b) of the Companies Act and Rule 12 of the Share Capital and Debentures Rules: the shareholders approve it (by ordinary resolution in a private company, special resolution otherwise, with MGT-14 filed for a special resolution), the board or a compensation committee issues grant letters, and the company keeps a register of options in Form SH-6. The scheme fixes the pool, eligibility, exercise price, vesting, exercise period and what happens on leaving. Options cannot be granted to promoters or to directors holding over 10% of equity, except in a DPIIT-recognised startup for ten years from incorporation.
Each grant letter states the number of options, the exercise price (often the face value or a discount to fair value), the vesting schedule with its cliff, and the exercise window. On exercise the employee pays the exercise price, the company allots shares and files PAS-3, and the employee becomes a shareholder with whatever rights the articles give. Many startups use a trust or a nominee arrangement to keep the cap table simple, and most SHAs give investors a drag and tag over ESOP shares like any other.
Tax falls in two stages. At exercise, the difference between the fair market value (certified by a merchant banker for unlisted shares) and the exercise price is a salary perquisite taxed at slab rates, and the company deducts TDS on it. For an eligible startup certified under Section 80-IAC, that TDS is deferred under Section 192(1C) to the earliest of 48 months from the end of the relevant assessment year, the sale of the shares, or the employee leaving. At sale, the gain over the fair value used at exercise is a capital gain: long-term after 24 months for unlisted shares, taxed at 12.5% without indexation, and short-term at slab rates.
A Gurugram SaaS company creates a 10% pool at its seed round and grants a product manager 2,000 options at ₹10 each in 2026 when the fair value is ₹400. In 2030, with all options vested and fair value at ₹2,500, she exercises and pays ₹20,000; the perquisite of ₹49.8 lakh is taxed as salary that year, or deferred because the company holds an 80-IAC certificate. When the company is acquired in 2032 at ₹4,000 a share, her gain of ₹30 lakh over the ₹2,500 fair value at exercise is a long-term capital gain at 12.5%.
Mistakes we see with ESOP
- Promising equity in offer letters before any scheme exists, which creates expectations the board later cannot grant on those terms.
- Granting options to a co-founder holding 15% without DPIIT recognition, which Rule 12 prohibits.
- Setting a 90-day post-exit exercise window and then watching good leavers forfeit vested options because they cannot fund the perquisite tax.
- Issuing the ESOP pool as actual shares to a trust without a scheme, which dilutes the cap table at once and complicates every later valuation.
Last updated 19 October 2026. Checked against the MCA, GST, Income-tax and Trade Marks rules in force for October 2026.
Where you will meet this term
- ESOP Planning & StructuringPrivate Limited Companies that want to hire with equity: pool sizing, a scheme the board can approve, the MGT-14 filing and grants that hold up at exit.from ₹39,999
- CFO ServicesFunded startups and growing companies that need a finance head for a few hours a week: runway, board packs, budgets and fundraise support, without a full-time hire.from ₹24,999/month
- Start-up India RegistrationFor a Pvt Ltd, LLP or registered partnership under 10 years old that wants DPIIT recognition and a shot at the 80-IAC tax holiday.from ₹4,999
Questions founders ask about ESOP
Can an LLP give ESOPs?
No. Options over shares exist only in companies, and an LLP has no shares. An LLP can admit a key person as a partner with a small profit share or promise a cash bonus linked to value, but a true ESOP needs conversion to a private limited company first.
How big should the ESOP pool be?
Early-stage pools are commonly 8% to 15% of fully diluted equity, set so the next two years of senior hires can be covered. Investors usually require the pool to be created or topped up before their round, in the pre-money, so the dilution falls on the founders; negotiate the size against a real hiring plan.
When does an employee pay tax on ESOPs?
On exercise, as a salary perquisite on the gap between fair market value and exercise price, with TDS through payroll; and on sale, as capital gains on the rise since exercise. Employees of an 80-IAC-certified startup get the exercise-stage tax deferred for up to four years or until they sell or leave.