Employee Stock Option Plan (ESOP)

Employee Stock Option Plan (ESOP): complete guide

Introduction

An Employee Stock Option Plan, or ESOP, gives employees the right to buy shares in the company they work for at a pre-determined price, after a set period of service. For startups and growing companies, ESOPs are one of the most effective ways to attract and keep talented people. They let a company offer a share in its future success when it may not be able to match the cash salaries of larger employers, and they align employees' interests with those of the founders and investors.

In India, ESOPs for companies are governed mainly by Section 62(1)(b) of the Companies Act, 2013 and Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014 for unlisted companies. Listed companies follow the share-based employee benefits regulations of the securities regulator. The law requires the scheme to be approved by a special resolution of the shareholders, sets a minimum vesting period, restricts who can receive options, and requires specific disclosures. Tax law treats the benefit as a perquisite in the employee's hands when shares are allotted on exercise, and as capital gains when the shares are later sold, with a deferral of tax available to employees of certain eligible startups.

A well-designed ESOP needs more than a template. The size of the option pool, the vesting schedule, the exercise price, what happens when an employee leaves, how options are treated on a sale of the company, and whether the company uses a trust to hold shares are all choices that affect founders, employees and investors. Investors will check that the plan is properly approved and that grants match the cap table. Employees will want to understand the tax consequences. A poorly drafted or improperly approved plan can create disputes, tax surprises and delays in fundraising or exit.

Our team of company secretaries, chartered accountants and advocates helps you design the scheme, draft the ESOP policy and grant documents, obtain board and shareholder approvals, file the required forms, and set up the records you need to manage the plan. This page explains who needs an ESOP, the legal requirements, the step-by-step process, documents, timelines, our fee and what happens after the plan is in place.

Who Needs It

An ESOP is useful for:

• Startups competing for talent, who want to offer equity to early employees instead of, or in addition to, higher salaries.
• Venture-funded companies, where investors expect an option pool to be created or expanded as part of a funding round.
• Growing private companies that want to reward and retain senior managers and key technical staff.
• Companies preparing for an exit or listing, which want employees to share in the value created.
• Subsidiaries of foreign companies, where employees in India may receive options in the parent company or the Indian subsidiary, subject to foreign exchange rules.
• Family-owned companies bringing in professional managers who expect a long-term stake.
• Companies replacing informal promises, where founders have verbally promised equity to employees and want to put this on a proper legal footing.

ESOPs under the Companies Act can be issued by companies, both private and public. LLPs and partnership firms cannot issue shares, so they cannot have ESOPs in this form, though they may consider other incentive arrangements.

Key Benefits

• Attracting talent. Equity is a strong draw for skilled people who believe in the company's growth.
• Retention. Vesting schedules encourage employees to stay with the company to earn their options.
• Cash conservation. Options let a company offer meaningful rewards without large cash payments, which is valuable in the early years.
• Alignment of interests. Employees who own a stake think like owners and are invested in the company's long-term success.
• Investor comfort. A properly approved ESOP pool, reflected in the cap table, is expected by most investors and avoids issues during due diligence.
• Tax deferral for eligible startups. Employees of eligible startups may defer payment of tax on the perquisite until a later event, easing the cash burden at exercise.
• Flexibility. The plan can be tailored with different vesting schedules, performance conditions and exercise terms for different groups of employees.

How an ESOP works in practice. The company first creates a scheme and sets aside a pool of shares. Options are then granted to eligible employees, each with an exercise price and a vesting schedule. Over time, the options vest, meaning the employee earns the right to buy the shares. A common structure is vesting over four years, with a one-year cliff, but the minimum gap between grant and vesting under the rules for unlisted companies is one year. After vesting, the employee can exercise the options by paying the exercise price, and the company then allots the shares. The employee becomes a shareholder and can sell the shares when an opportunity arises, such as a secondary sale, buy-back, acquisition or listing.

ESOP, sweat equity and phantom stock. ESOPs give employees an option to buy shares later. Sweat equity shares, by contrast, are issued at a discount or for consideration other than cash in recognition of know-how or value added, and follow a separate set of rules. Phantom stock or stock appreciation rights give employees a cash payment linked to the value of shares, without issuing actual shares. We explain these alternatives and help you choose the right instrument for your goals.

Eligibility and Legal Requirements

The key legal requirements for an ESOP in an unlisted company are:

• Special resolution. The scheme must be approved by a special resolution of the shareholders. The explanatory statement to the notice must contain the disclosures listed in Rule 12, such as the total number of options, the classes of eligible employees, the vesting requirements, the exercise price or pricing formula, the exercise period, the lock-in, if any, and the maximum number of options per employee.
• Eligible employees. Options can be granted to permanent employees of the company working in or outside India, to directors of the company whether whole-time or not, other than independent directors, and to employees and directors of a subsidiary or holding company, in India or abroad.
• Persons not eligible. Options cannot be granted to an employee who is a promoter or belongs to the promoter group, or to a director who, directly or indirectly, holds more than 10 percent of the outstanding equity shares of the company, either alone or through relatives or a body corporate.
• Startup exception. A company recognised as a startup under the government's notification may grant options to promoters, promoter group members and directors holding more than 10 percent of the shares, for up to ten years from its date of incorporation or registration.
• Minimum vesting period. There must be a minimum period of one year between the grant of options and their vesting. In the case of death or permanent incapacity of the employee, the options can vest immediately.
• Exercise price. The company may decide the exercise price, subject to compliance with applicable accounting policies.
• Options are non-transferable. Options cannot be transferred, pledged or otherwise dealt with. They can be exercised only by the employee, except in the case of death, when they pass to the legal heirs or nominees.
• Separate resolution for some grants. Grants to employees of a subsidiary or holding company, and grants to an individual employee in any one year that are equal to or more than one percent of the issued capital, need separate approvals as set out in the rules.
• Register and disclosures. The company must maintain a register of employee stock options in Form SH-6, and make disclosures about the scheme in the board's report each year.
• Filings. The special resolution must be filed in Form MGT-14 within 30 days of passing. When shares are allotted on exercise, a return of allotment must be filed in Form PAS-3 within the time allowed.
• Authorised capital. The company must have enough authorised share capital to allot shares on exercise. Where needed, authorised capital must be increased first.
• Tax. When shares are allotted on exercise, the difference between the fair market value of the shares and the exercise price is taxed as a perquisite in the employee's hands, and the company deducts tax at source. When the employee later sells the shares, any gain is taxed as capital gains. Employees of eligible startups may defer tax on the perquisite until the earliest of the prescribed events, such as the sale of shares, leaving the company, or the expiry of the period set by law. For unlisted shares, fair market value is determined by a valuation report as required by the tax rules.
• Foreign exchange rules. Issue of ESOPs to employees resident outside India, and acquisition of shares of a foreign parent by Indian employees, must follow the applicable foreign exchange rules and reporting requirements.

Listed companies must follow the share-based employee benefits regulations of the securities regulator instead of Rule 12. Company law, tax law and foreign exchange rules relating to ESOPs change from time to time, and we check the current position at the time of drafting and filing.

Step-by-Step Guide

1. Initial consultation. We discuss your goals for the ESOP, the employees you want to cover, your current cap table, investor requirements and your plans for funding or exit.
2. Plan design. We help you decide the size of the option pool, the vesting schedule and any cliff, performance conditions, exercise price, exercise period, treatment of leavers and treatment on a change of control.
3. Choice of structure. We advise whether options should be granted directly by the company or administered through an employee welfare trust, and explain the implications of each.
4. Review of Articles and agreements. We check the Articles of Association and any shareholders agreement for provisions on share issues, investor consent and pre-emption rights, and recommend amendments where needed.
5. Drafting the ESOP scheme. We draft the ESOP policy document covering eligibility, grant, vesting, exercise, lapse, adjustments for corporate actions, administration and tax.
6. Board approval. We draft the board resolution approving the scheme, the explanatory statement, and the notice of the general meeting.
7. Shareholder approval. Shareholders pass the special resolution approving the scheme, with separate resolutions where required for specific grants.
8. Filing Form MGT-14. We file the special resolution and scheme with the Registrar in Form MGT-14 within 30 days of passing.
9. Grant documents. We draft the grant letter template, the vesting schedule and the exercise form, and set up the register of employee stock options in Form SH-6.
10. Handover and employee communication. We share the approved scheme and templates, and can provide a plain-language note for employees explaining how the plan works and how it is taxed.

Documents Checklist

From the company:

• Certificate of incorporation, and Memorandum and Articles of Association
• Current shareholding pattern and cap table, including convertible instruments
• Shareholders agreements and investment agreements
• Latest audited financial statements
• Details of authorised and paid-up share capital
• Startup recognition certificate, if the company is a recognised startup
• Digital Signature Certificate of a director to sign the forms

For plan design:

• Proposed size of the option pool as a percentage of share capital
• Proposed eligibility criteria and classes of employees
• Preferred vesting schedule, cliff and any performance conditions
• Proposed exercise price or pricing method
• Any investor term sheet requirements relating to the ESOP pool

For grants and exercise:

• List of employees to receive initial grants, with designation and number of options
• Valuation report for the shares, for fixing the exercise price and computing tax at exercise, as applicable
• Employee PAN and contact details for the register

Where a trust is used:

• Draft trust deed and details of trustees
• Details of funding arrangements for the trust

How Long It Takes

Setting up an ESOP usually takes two to four weeks from the date we receive the information needed to design the plan. A typical timeline is:

• Consultation and plan design: three to five working days, depending on how quickly key decisions are made.
• Drafting of the scheme and resolutions: three to five working days, with revisions based on your feedback.
• Investor consent, where needed: depends on the investors and the terms of the shareholders agreement.
• Board meeting and general meeting: depends on the notice period. A general meeting needs clear notice under the Act, unless shorter notice is agreed by the required majority of shareholders.
• Filing Form MGT-14: usually within one to two working days of the meeting.
• Grant documents and register: two to three working days after approval.

Where the Articles need to be amended, authorised capital increased or a trust set up, additional time is needed.

Pricing

Our professional fee for Employee Stock Option Plan (ESOP) is ₹ 14,999.

This covers:

• Consultation on plan design, pool size, vesting and exercise terms
• Review of the Articles of Association and shareholders agreement
• Drafting of the ESOP scheme document
• Drafting of board resolution, notice of general meeting, explanatory statement and special resolution
• Preparation and filing of Form MGT-14
• Grant letter, vesting schedule and exercise form templates
• Format of the register of employee stock options in Form SH-6
• A plain-language explanatory note for employees

Government fees are payable at actual. Valuation reports, setting up an employee welfare trust, amendments to the Articles, increase in authorised capital, foreign exchange filings, allotment of shares on exercise with Form PAS-3, and ongoing ESOP administration are quoted separately where needed.

Common Mistakes to Avoid

• Promising options without a scheme. Offer letters that promise equity without an approved scheme create legal uncertainty and disputes.
• Granting options to ineligible persons. Promoters and directors holding more than 10 percent cannot receive options unless the startup exception applies.
• Vesting earlier than one year. The rules require at least one year between grant and vesting, except in cases of death or permanent incapacity.
• Inadequate authorised capital. If the company lacks enough authorised capital, it cannot allot shares when employees exercise.
• Ignoring investor rights. Many shareholders agreements require investor consent for creating or expanding an ESOP pool.
• No valuation at exercise. For unlisted shares, a valuation is needed to compute the employee's perquisite and the company's tax deduction obligation.
• Unclear leaver provisions. The scheme should clearly state what happens to vested and unvested options when an employee resigns, is dismissed, retires or dies.
• Not maintaining the register. The register of employee stock options must be kept up to date with grants, vesting, exercise and lapse.
• Poor employee communication. Employees who do not understand vesting, exercise and tax may be disappointed later, which defeats the purpose of the plan.

What Happens After

Once the scheme is approved, the company starts granting and managing options. Ongoing steps include:

• Issuing grant letters to employees with the number of options, exercise price and vesting schedule.
• Maintaining the register of employee stock options in Form SH-6 with every grant, vesting, exercise and lapse.
• Board's report disclosures about the scheme each year, as required by the rules.
• Accounting for share-based payments in the financial statements as per the applicable accounting standards.
• Processing exercises, which involves receiving the exercise price, obtaining a valuation where needed, deducting tax at source on the perquisite, allotting shares and filing Form PAS-3 within the time allowed.
• Updating the cap table after every allotment.
• Handling leavers and corporate events, such as lapses on resignation or accelerated vesting on an acquisition, as provided in the scheme.
• Reviewing the plan periodically, especially before a new funding round, to see whether the pool needs to be expanded.

Our team can provide ongoing ESOP administration, including grants, exercises, allotments, filings and employee queries.

FAQs

Can a private limited company issue ESOPs?

Yes. Private and unlisted public companies can issue ESOPs under Section 62(1)(b) of the Companies Act and Rule 12 of the share capital rules, after shareholders approve the scheme by special resolution.

Can founders receive ESOPs?

Generally, no. Promoters, promoter group members and directors holding more than 10 percent of the shares are not eligible. However, a recognised startup may grant options to them for up to ten years from incorporation.

Can independent directors receive ESOPs?

No. Independent directors are excluded from receiving stock options under the rules.

What is the minimum vesting period?

There must be at least one year between the grant of options and their vesting. In the case of death or permanent incapacity of the employee, options can vest earlier.

How are ESOPs taxed in India?

When shares are allotted on exercise, the difference between the fair market value and the exercise price is taxed as a perquisite in the employee's hands. When the shares are later sold, the gain is taxed as capital gains.

What is the tax deferral for startup employees?

Employees of eligible startups can defer tax on the perquisite until the earliest of certain events, such as the sale of the shares, leaving the company, or the end of the period set by law. The company must meet the conditions for eligibility.

What happens to options when an employee leaves?

This depends on the scheme. Usually, unvested options lapse, and the employee has a set period to exercise vested options. The scheme should clearly set out the rules for different types of leavers.

Do we need investor consent to create an ESOP pool?

Often, yes. Most investment agreements require investor approval for creating or expanding an option pool. We check your agreements before drafting.

How large should the ESOP pool be?

There is no legal limit for unlisted companies, but the size should be planned against hiring needs and dilution. Pools are often expanded at funding rounds, as negotiated with investors.

Can employees of a foreign parent's Indian subsidiary receive options?

Yes. Employees of a subsidiary can receive options of the Indian holding company, and Indian employees can receive options in a foreign parent, subject to the applicable foreign exchange rules and reporting.

Is a valuation required for ESOPs?

For unlisted companies, a valuation is generally needed to determine the fair market value for tax purposes at the time of exercise, and it is also useful for fixing the exercise price.

What is an employee welfare trust?

It is a trust set up to hold and administer shares for employees under the ESOP. It can make administration easier, especially for companies with many employees, but involves additional documentation and rules.

Can options be transferred to family members?

No. Options cannot be transferred, pledged or otherwise dealt with. In the case of an employee's death, the options pass to their legal heirs or nominees.

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