ESOPs for startups, explained

What is an ESOP and how does it work?

An Employee Stock Option Plan is a scheme under which a company grants employees options: the right, not the obligation, to buy a fixed number of shares at a fixed price (the exercise price) after certain conditions are met. The employee gains if the shares are worth more than the exercise price when they exercise and sell.

The lifecycle has five steps:

• Grant: the company issues a grant letter stating the number of options, exercise price, vesting schedule and expiry.
• [Vesting](/glossary/vesting/): options become exercisable over time, typically 25% after a one-year cliff and then monthly or quarterly over the next three years.
• Exercise: the employee pays the exercise price and receives shares.
• Holding: the employee is now a shareholder, often with restrictions on transfer until a liquidity event.
• Sale: shares are sold in a secondary sale, buyback or acquisition, or listed.

Only companies can grant ESOPs. An LLP has no shares, so it can only offer profit-sharing or partnership interests, which is one reason venture-backed startups choose the Private Limited structure. Our ESOP Planning service designs the scheme and the paperwork; the ESOP Pool Calculator shows the dilution for any pool size.

How big should the ESOP pool be?

A pool of 5% to 15% of the fully diluted equity is the norm for Indian startups, with 10% the most common starting point at seed stage. The pool is a reservation, not an issuance: shares are created only when options are exercised, but investors count the whole pool as if issued when they calculate their ownership.

Three factors decide the size:

• Hiring plan for the next 18 to 24 months. A pool sized for the people you will hire before the next round, with a buffer, is easier to defend than a round number.
• Investor expectations. Most seed and Series A term sheets require the pool to be created or topped up before the round, so the dilution falls on founders, not the new investor. Negotiate the size with the hiring plan in hand.
• Grant sizes by level. Early senior hires often receive 0.5% to 2%, mid-level engineers 0.1% to 0.5%, and later hires less as the company's value rises.

A pool that is too large dilutes founders for no benefit; one that is too small forces a top-up at the next round on worse terms. Re-examine the pool at every funding round rather than setting it once.

What are vesting, cliff and exercise price?

Vesting is the schedule on which options become exercisable. Four years is standard, and it aligns the employee's reward with staying and building.

[Cliff](/glossary/cliff/) is the initial period, usually one year, during which nothing vests. An employee who leaves inside the cliff forfeits all options. After the cliff, the first 25% vests at once and the balance vests in equal monthly or quarterly instalments.

Exercise price is what the employee pays per share. Indian startups commonly set it at or near face value (₹10 or even ₹1) rather than fair market value, because a low exercise price makes the grant meaningful at an early stage and the Companies Act does not require exercise at market price for unlisted companies. The trade-off is a higher perquisite tax at exercise, described below.

Exercise window is the period after vesting, and especially after leaving, in which an employee must exercise or lose the options. Ninety days after leaving is common but harsh; many founder-friendly schemes allow exercise until a liquidity event.

Accelerated vesting on an acquisition (single or double trigger) and treatment on death, disability or termination for cause are the clauses that cause disputes later, so the scheme should state them plainly.

How are ESOPs taxed for the employee?

An employee is taxed twice, at two different points.

At exercise: the difference between the fair market value of the shares on the exercise date and the exercise price is a perquisite, taxed as salary at the employee's slab rate. The fair market value of an unlisted company's shares is determined by a merchant banker's valuation report. The company must deduct TDS on this perquisite in the month of exercise, which can be a large cash outflow before any shares are sold.

At sale: the difference between the sale price and the fair market value used at exercise is a capital gain. For unlisted shares held more than 24 months it is a long-term gain taxed at 12.5% without indexation; otherwise it is short-term and taxed at slab rates.

The [DPIIT](/glossary/dpiit/) deferral: employees of an eligible startup recognised by DPIIT can defer the tax on the exercise perquisite to the earliest of 48 months from the end of the tax year of exercise, the sale of the shares, or leaving the company. This solves the cash problem at exercise and is a strong reason for a startup to obtain Startup India recognition. The Income-tax Act 2025 applies from 1 April 2026 and renumbers sections; the treatment above is unchanged in substance.

What does the company need to do under the Companies Act?

An ESOP is governed by Section 62(1)(b) of the Companies Act 2013 and Rule 12 of the Share Capital and Debentures Rules. The steps for a Private Limited Company:

• Draft the scheme covering eligibility, pool size, vesting, exercise price, exercise period, treatment on exit, and the administering committee.
• Board approval of the scheme at a board meeting.
• Special resolution of shareholders at a general meeting, with an explanatory statement disclosing the total options, identified classes of employees, vesting, exercise price and the accounting method.
• File MGT-14 with the resolution within 30 days.
• Grant letters to employees and a register of options in Form SH-6.
• Allotment on exercise by board resolution and PAS-3 within 30 days, followed by share certificates and stamp duty.

Who can receive options: permanent employees and directors of the company and its subsidiaries and holding company, but not promoters or directors holding more than 10% of equity, except in a DPIIT-recognised startup for its first ten years. Independent directors are excluded. The scheme also needs an annual disclosure in the directors' report and accounting for the fair value of options as an expense over the vesting period, which the auditor will expect.

ESOP, sweat equity, phantom stock: which should you use?

An ESOP is the right tool for employees in a company that expects a liquidity event. Two alternatives suit specific cases.

Sweat equity is the issue of shares (not options) at a discount or for non-cash consideration to employees or directors for know-how or value added. It is capped at 15% of paid-up capital in a year and 25% overall (50% for a DPIIT startup in its first ten years), needs a special resolution and a valuation, and the shares are locked in for three years. Founders sometimes use it to bring in a technical co-founder who joins after incorporation.

Phantom stock or stock appreciation rights pay cash equal to the rise in share value without issuing shares. They avoid dilution and Companies Act filings but create a cash liability, and the payout is taxed as salary. They suit companies that never plan to give employees real ownership, such as family businesses.

Direct share issue to advisors is usually a mistake: it creates a shareholder with rights before the advisor has delivered. Options with a short vesting schedule work better.

For a venture-backed startup, an ESOP under Section 62 remains the standard because every investor's term sheet assumes it and every employee understands it.

What mistakes should you avoid?

• Granting before the scheme exists. Promising a percentage in an offer letter without a board- and shareholder-approved scheme creates a claim the company cannot honour cleanly.
• Promising percentages instead of numbers. Grant a number of options against a stated fully diluted share count on the grant date. Percentages shrink with each round and lead to disputes.
• A 90-day post-exit exercise window with a high exercise price. Employees who leave cannot afford to exercise and lose everything, which destroys the retention value for those who stay.
• Ignoring the tax at exercise. Tell employees in writing that exercise triggers perquisite tax, and obtain DPIIT recognition so the deferral is available.
• Not filing MGT-14 and not keeping SH-6. These are the documents an investor's due diligence asks for first.
• Forgetting the valuation. The perquisite needs a merchant banker's fair value on the exercise date; a management estimate does not satisfy the tax department.
• Skipping the accounting. The fair value of options is an expense over the vesting period; auditors qualify accounts that omit it.

Get the scheme right once, communicate it in plain language to employees, and revisit the pool at every round.