ESOP Scheme Design in Indian Startup Tax: Structure Vesting, Exercise, Exit

An ESOP scheme in an Indian startup is not just a retention document. It is a tax structure. Every design decision a founder makes at grant time, from exercise price to vesting cliff to when employees are told to exercise, has a direct consequence on what the employee pays to the government at the end. Most founders learn this the hard way when their star engineer exercises options ahead of an acquisition and faces a ₹40 lakh perquisite tax bill with no cash to pay it.

This guide works through the complete lifecycle of an ESOP scheme (grant, vesting, exercise, and exit) from a tax design perspective. It covers the legal framework under the Companies Act 2013 and the Income Tax Act 2025, the DPIIT startup deferral and its precise eligibility conditions, the FMV valuation requirements that determine what TDS is actually deducted, and the capital gains treatment across three exit routes. Every section is written for the founder who is sitting across the table from a compensation committee and needs to know which variable to control.

The legal framework every unlisted startup must follow

An Indian unlisted private limited company issues ESOPs under Section 62(1)(b) of the Companies Act 2013, read with Rule 12 of the Companies (Share Capital and Debentures) Rules 2014. These two provisions, together, govern everything from how the scheme is approved to what the grant letter must say.

The statutory requirements are specific. The scheme must be approved by shareholders through a special resolution, though the MCA exemption notification allows private companies to use an ordinary resolution. The resolution must specify the total number of options to be granted, the eligibility criteria, the vesting period and conditions, the exercise price and method of its determination, the exercise period, the appraisal process for determining eligibility, and the maximum number of options that can be granted per employee. There must be a minimum gap of one year between the grant date and the first vesting date. This is a hard statutory floor under Rule 12(1)(b), not a market convention.

ESOPs cannot be granted to promoters or persons belonging to the promoter group, with one important exception. Under Rule 12 Explanation, a DPIIT-recognised startup is allowed to grant ESOPs to promoters and directors holding more than 10% equity, for a window of 10 years from the date of incorporation. For founder-led startups that want to give equity incentives to co-founders who are not full-time employees, this DPIIT exception is the only legal path.

For listed companies, the SEBI (Share Based Employee Benefits and Sweat Equity) Regulations 2021 apply in addition to the Companies Act framework. These regulations require a compensation committee composed primarily of independent directors, detailed annual disclosures in the directors’ report, and scheme approval via special resolution on a stock exchange platform. Pre-IPO startups planning to list within two to three years should design their ESOP scheme to be SEBI SBEB 2021-compliant from the outset, so the transition does not require a complete scheme rewrite.

How much equity to put in the ESOP pool, and when

The ESOP pool is the total percentage of fully diluted equity reserved for employee options. Indian startups typically set the pool at 10 to 15% of fully diluted capital. The actual percentage is a function of stage and hiring plan: Pre-Seed and Seed companies reserve 8 to 12%, Series A companies reserve 12 to 15%, and late-stage companies running refresh grant programmes operate pools of 15 to 20%.

The most important timing decision is when to create the pool relative to fundraising. Investors in term sheets almost universally require that the ESOP pool be created on a pre-money basis, meaning the dilution of the pool comes from existing shareholders, not from the new investment. If a Series A investor requires a 15% post-money ESOP pool and the company currently has a 5% pool, the additional 10% is carved from the pre-money cap table. Creating the pool at the right size before the fundraising round, and not under investor pressure during it, gives founders more control over this dilution.

A second practical point: options that are not yet granted do not dilute the cap table economically, but they appear in the fully diluted count that investors use for valuation. Founders should model the ESOP pool in their cap table waterfall before opening investor conversations.

Grant design: exercise price, vesting, and acceleration

What exercise price should a startup set?

The exercise price is the amount the employee pays to convert a vested option into a share. It is a critical tax design variable because the perquisite tax at exercise is calculated on the spread between FMV and exercise price. A low exercise price means a larger spread, a higher perquisite value, and a higher tax bill for the employee at exercise. A high exercise price reduces the perquisite but reduces the option’s value to the employee.

Indian startup practice has converged on two approaches. Growth-stage startups that want the option to be genuinely in-the-money set the exercise price at the last fundraise price per share or at a nominal discount to it. Early-stage startups that want to minimise employee tax exposure set the exercise price at face value (₹10 per share) or at a small premium to face value. Both are legally permissible. The Companies Act and Rule 12 do not prescribe a minimum exercise price for unlisted companies.

The tax-planning implication is important. If an employee exercises at a ₹10 exercise price when FMV is ₹500, the perquisite is ₹490 per share, taxed as salary at up to 42.7% (30% slab plus surcharge and cess for high earners). If the same employee exercises at ₹400 when FMV is ₹500, the perquisite is ₹100 per share. For a 5,000-share grant, the difference in perquisite tax exposure is ₹19.5 lakh versus ₹3.9 lakh. This is why later-stage startups with higher valuations often set exercise prices closer to market value: it protects employees from a large non-cash tax liability.

Is it always better to set a high exercise price?

Not necessarily. A high exercise price means the employee pays more cash to exercise. In a pre-liquidity company, the employee is paying cash for shares that cannot be sold. That creates its own retention problem: employees may choose not to exercise at all, which defeats the purpose of the scheme. The right exercise price balances the tax efficiency with the exercisability. One approach is to set a modest exercise price (₹100 to ₹200 per share for mid-stage startups) with a formal liquidity programme (a periodic buyback or secondary market arrangement) so employees have a mechanism to sell at least some shares after exercise.

What vesting schedule design works best?

The standard Indian startup vesting schedule is four years with a one-year cliff: 25% vests at the end of year one, and the remaining 75% vests in equal monthly or quarterly instalments over years two, three, and four. This structure is well-understood by employees, investors, and courts. Deviating from it requires a specific reason, and that reason should be documented in the scheme.

Shorter vesting periods (two to three years) can work for senior hires at later stages where four-year retention is not realistic, or for advisor grants where a one-year or two-year schedule is more proportionate to the engagement. Longer vesting periods (five or six years) are used occasionally for founding-team grants, but they create a retention problem if the company takes longer than expected to reach liquidity.

Milestone-based vesting (where vesting is tied to revenue targets, product launches, or funding milestones rather than time) is legally permissible under Rule 12 but practically problematic. Milestone definitions become the subject of disputes when milestones are missed or ambiguously met. Time-based vesting, with performance criteria layered at the grant level (conditional on continued good performance as determined by the board), is the cleaner design.

Double-trigger acceleration is a clause that accelerates unvested options when two events happen simultaneously: a change of control (acquisition or merger) and the employee’s termination without cause within a specified window after the change of control, typically 12 to 18 months. This is the market-standard protection for employees in M&A situations. Single-trigger acceleration (vesting on the change of control alone) is less common and creates complications in M&A negotiations because the acquirer acquires a fully vested option pool on day one.

Vesting design element	Standard structure	When to deviate
Total vesting period	4 years	Shorter for advisors; may be longer for co-founders
Cliff	1 year (statutory minimum)	Cannot reduce below 1 year under Rule 12(1)(b)
Post-cliff cadence	Monthly or quarterly	Quarterly is administratively simpler for most startups
Acceleration on M&A	Double-trigger	Single-trigger only if specifically negotiated with acquirer
Acceleration on termination without cause	Optional but recommended	Standard in ESOP schemes for senior hires from Series A onward

The two-stage tax model: how ESOP income is taxed

ESOP taxation in India under the Income Tax Act 2025 (which replaced the Income Tax Act 1961 from 01 April 2026) happens at exactly two points. The framework is carried forward unchanged from the 1961 Act, with section numbering updated and one important change to the deferral window for eligible startups.

Stage 1: perquisite tax at exercise

When an employee exercises vested options, a taxable event occurs. The perquisite value is:

Perquisite = (FMV on exercise date) minus (Exercise price) multiplied by (Number of shares exercised)

This amount is added to the employee’s salary income for that financial year and taxed at the applicable slab rate. For most senior startup employees, the applicable slab is 30% plus surcharge and cess, which produces an effective rate of approximately 31.2% to 42.7% depending on total income and surcharge category. The employer (the startup) is responsible for deducting TDS on this perquisite under Section 392 of the IT Act 2025 (successor to Section 192 of the 1961 Act) in the month of exercise.

The critical practical problem: the employee has not received any cash. They have received shares in an unlisted company that they cannot sell on a stock exchange. Yet the perquisite tax is due immediately. This is the liquidity trap at the heart of ESOP taxation for private company employees, and it is the primary reason the DPIIT deferral exists.

Stage 2: capital gains at sale

When the employee eventually sells the shares, a second tax event occurs. The capital gain is:

Capital gain = Sale price minus FMV on exercise date

Because FMV at exercise was already taxed as a perquisite, it becomes the cost of acquisition for capital gains purposes. There is no double taxation on the same gain. The applicable tax rate depends on the holding period from exercise date to sale date, and whether the shares are listed or unlisted at the time of sale.

For unlisted shares (all Indian startups before IPO):

• Short-term capital gain (held 24 months or less): taxed at income slab rate
• Long-term capital gain (held more than 24 months): taxed at 12.5% without indexation

For listed shares (post-IPO):

• Short-term capital gain (held 12 months or less): taxed at 20%
• Long-term capital gain (held more than 12 months): taxed at 12.5%, with a ₹1.25 lakh annual exemption on LTCG from listed equity

The 24-month holding period for unlisted shares is the key tax planning variable at exit. An employee who sells shares within 24 months of exercise pays slab-rate tax on the capital gain (up to 30% plus surcharge). The same employee who waits 24 months from exercise pays 12.5%. In a transaction where the capital gain is ₹50 lakh, the difference is approximately ₹8.75 lakh in tax. The 24-month clock starts from the exercise date, not the grant date or vesting date.

FMV valuation: why the merchant banker requirement is non-negotiable

For unlisted companies (which covers all Indian startups before IPO) FMV must be certified by a Category I Merchant Banker registered with SEBI. This requirement comes from Rule 3(8) read with Rule 3(9)(ii) of the Income Tax Rules 1962. A Chartered Accountant’s valuation is not sufficient for this purpose, regardless of the CA’s qualifications or the methodology used.

The valuation must be current: Rule 3 requires that the merchant banker report not be older than 180 days from the date of exercise. A startup that raises a Series B round in January, gets a valuation report at that time, and then runs an exercise window in November of the same year is likely outside the 180-day window. A fresh valuation report is required for each exercise event where the prior report has expired.

The Income Tax Department scrutinises FMV certificates for unlisted shares, particularly when the FMV appears low relative to the company’s last fundraising valuation. A merchant banker valuation that is materially lower than the most recent funding round price, without a documented basis for the difference, can attract additions to income, interest under the applicable provisions, and penalty. Founders who try to suppress the FMV to reduce employee perquisite tax exposure create a risk for both the company and the employee.

One common founder question: can the same valuation report prepared for a fundraise or an ESOPs grant serve as the FMV certificate for the exercise event? The answer depends on the date. If the report falls within 180 days of the exercise, it can be used. Most of the time, the fundraise report and the exercise window are separated by more than six months, so a fresh report is necessary. Building the cost of a merchant banker FMV report into the exercise window planning calendar is a basic compliance hygiene step.

The DPIIT perquisite tax deferral: what it is and who actually qualifies

The single most valuable tax benefit available to Indian startup employees under their ESOP scheme is the perquisite tax deferral for eligible startups. Under Section 392(3) read with Section 289(3) of the Income Tax Act 2025 (successor to Section 192(1C) of the 1961 Act), an employee of an eligible startup can defer the perquisite tax at exercise until the earliest of:

• 60 months from the end of the Tax Year in which the shares were allotted (for shares allotted on or after 01 April 2026)
• The date the employee sells the shares
• The date the employee ceases to be an employee of the company

This solves the liquidity trap described above. Instead of paying tax in the year of exercise on a non-cash gain, the employee defers the payment until there is a liquidity event (sale) or the deferral window expires. The tax rate applied is the slab rate in force for the Tax Year of allotment, not the year in which the deferral trigger occurs. This means a slab rate increase between exercise and sale date does not retrospectively increase the deferred tax.

The prior 1961 Act provided a 48-month window. The IT Act 2025 extended this to 60 months for shares allotted on or after 01 April 2026. This is a material improvement for pre-IPO startups whose liquidity timelines extend to five years.

Who actually qualifies: the IMB certification requirement

This is where most founders make an expensive assumption. DPIIT recognition is necessary but not sufficient. To unlock the ESOP tax deferral, the company must also hold a valid Inter-Ministerial Board (IMB) Certificate, which confirms eligibility under Section 140 of the IT Act 2025 (the successor to Section 80-IAC of the 1961 Act). The eligibility conditions are:

• Incorporated as a Private Limited Company or LLP between 01 April 2016 and 31 March 2030
• Annual turnover in any of the prior financial years has not exceeded ₹100 crore
• DPIIT recognition is current and valid
• IMB certification has been obtained from the Inter-Ministerial Board of Certification under DPIIT

As of April 2025, approximately 3,700 startups out of 1.97 lakh DPIIT-recognised entities hold IMB certification. DPIIT recognition alone (obtained through a straightforward online process on the Startup India portal) does not qualify a company for the ESOP deferral. The IMB certification is a separate process requiring substantive review. Industry bodies including NASSCOM and AMCHAM have urged the government to extend deferral eligibility to all DPIIT-recognised startups, and this is under active policy consideration, but as of the time of writing, the IMB requirement stands.

The practical implication: if your startup does not yet hold IMB certification, your employees cannot defer perquisite tax. Obtaining IMB certification should be treated as a parallel priority to DPIIT recognition, not as an afterthought. Treelife has supported dozens of startups through the IMB certification process. It is not trivial, but it is achievable, and the retention and cash-flow benefit for employees is significant.

Important caution: the deferral is not an exemption. The tax is postponed, not eliminated. An employee who leaves the company before selling shares will owe the deferred perquisite tax within 14 days of separation, even if the shares are illiquid and no sale has occurred. This interaction between separation and deferral must be clearly communicated to employees before they exercise, and it should be documented in the scheme document and the grant letter.

What the IT Act 2025 changes for ESOP schemes

The Income Tax Act 2025 came into force on 01 April 2026, replacing the IT Act 1961 after 65 years. For ESOPs, the substantive framework is carried forward. Founders and HR teams need to know three things that are different:

First, the deferral window is extended to 60 months (from 48 months) for shares allotted on or after 01 April 2026. Shares allotted before that date continue under the 48-month window of the 1961 Act.

Second, section references have changed. Section 17(2)(vi) becomes the equivalent provision under the 2025 Act; Section 192(1C) becomes Section 392(3) read with Section 289(3); Section 80-IAC becomes Section 140. Any ESOP scheme document, grant letter, or employment contract that cites 1961 Act section numbers should be updated before the next exercise event.

Third, the “Tax Year” concept replaces the previous Assessment Year / Financial Year distinction. This changes how the deferral window is calculated and how ITR forms will report ESOP perquisites for Tax Year 2026-27 onwards.

Exercise window design: how timing controls tax exposure

The exercise window (when employees are permitted to exercise vested options) is a design decision that most startups treat as administrative. It is not. The exercise date determines the FMV used for perquisite calculation, the starting point of the capital gains holding period, and whether the employee has enough time to reach the 24-month LTCG threshold before a liquidity event.

Three design principles reduce tax friction for employees:

1. Avoid exercise windows immediately before a fundraise. A company that opens an exercise window in January and closes a Series C round in March will have employees computing their perquisite on a pre-Series C FMV. If the Series C round reprices the company substantially, the FMV used for the perquisite is already significantly lower than the round price. This creates an illusion of lower tax, but if the merchant banker valuation does not adequately reflect the imminent transaction, the IT Department may challenge it on scrutiny.

2. Build in a 24-month buffer before expected liquidity events. If the company anticipates a secondary transaction, buyback, or M&A exit in three years, consider opening an exercise window now. Employees who exercise today have their 24-month clock running. By the time liquidity arrives, they qualify for LTCG at 12.5% rather than slab-rate STCG. This alone can save a senior employee with a ₹1 crore capital gain approximately ₹17.5 lakh in tax.

3. Separate exercise windows from employment separation. A common source of disputes is employees who leave the company and are forced to exercise within 30 to 90 days of separation (the typical post-separation exercise window). If FMV at that point is high and the employee has no liquidity, they face a cash flow crisis. Designing a separation exercise window of 12 months, and for eligible startups ensuring the DPIIT deferral remains available to the departing employee for the balance of the deferral period, reduces this risk.

Exit routes and capital gains: the tax outcome differs significantly

The exit route determines both the timing and the rate of capital gains tax for the employee. The four common exit paths for Indian startup ESOP holders are: company buyback, secondary sale to an ESOP fund or incoming investor, M&A acquisition, and IPO followed by open-market sale.

Company buyback

Section 68 of the Companies Act 2013 governs share buybacks by Indian companies. A startup can buy back shares from employees through a tender offer. The capital gain for the employee is calculated as (buyback price minus FMV at exercise), and the holding period from exercise date to buyback date determines STCG or LTCG classification. Buybacks are predictable, scheduled, and increasingly common among Indian startups that cannot offer secondary liquidity through a stock exchange. The tax treatment is clean. No LTCG exemption of ₹1.25 lakh applies to unlisted shares, but the 12.5% LTCG rate applies once the 24-month threshold is met.

One design note: the buyback price must be equal to or less than the upper limit permitted under Section 68 read with Rule 17 of the Companies (Share Capital and Debentures) Rules. A buyback at a premium to last-round valuation requires a board resolution and full compliance with the buyback framework, including the buyback obligation with respect to free reserves and the buyback return filing with the Registrar of Companies.

Secondary sale

Employees may sell shares to a third party (an incoming investor, a secondaries fund, or a financial institution) in a secondary transaction. The capital gains treatment is identical to the buyback scenario. What differs is the price discovery mechanism. Secondary transactions for Indian unlisted startups are negotiated bilaterally, and the FMV certified by the merchant banker at exercise remains the cost of acquisition. Employees should document the original exercise FMV and exercise date carefully, as the IT Department may scrutinise the cost of acquisition claimed in a secondary sale.

FEMA considerations apply when the buyer is a non-resident. Any transfer of shares by a resident Indian to a non-resident must comply with FEMA (Non-Debt Instruments) Rules 2019, including pricing guidelines and Form FC-TRS filing within 60 days of the transaction.

M&A acquisition

A merger or acquisition typically triggers a buyout of all outstanding shares, including ESOP shares. The acquirer’s offer price becomes the sale price for capital gains purposes. Vesting acceleration clauses in the scheme document determine whether unvested options vest at the time of acquisition (double-trigger) or continue on the original schedule (no acceleration).

From a capital gains perspective, the employee’s tax depends entirely on how long they have held the shares since exercise. A common mistake: employees who hold exercised shares for fewer than 24 months at the time of the acquisition pay slab-rate tax on the capital gain, not LTCG. For large exits, this can mean the difference between 12.5% and 30% on gains that may be several crores. The exercise window design decision described above (exercising early, before the 24-month clock becomes critical) is most important for companies that anticipate an M&A exit.

IPO

Post-IPO, shares acquired under ESOPs of an unlisted company transition to listed status. The capital gains holding period resets to 12 months for LTCG qualification on the listed security. The 24-month clock for unlisted shares is not the relevant test once the company is listed; the question becomes whether the employee has held since exercise for more than 12 months. Employees who exercised within 12 months of the IPO listing date will face STCG at 20% on the post-IPO sale. Those who exercised more than 12 months before listing will qualify for LTCG at 12.5% after the ₹1.25 lakh exemption.

Exit route comparison table

Exit route	Capital gains basis	Holding period	Applicable rate	FEMA required
Company buyback	Buyback price minus FMV at exercise	From exercise date	12.5% LTCG if >24 months (unlisted); slab rate if ≤24 months	No (if both parties are residents)
Secondary sale (resident buyer)	Sale price minus FMV at exercise	From exercise date	Same as buyback	No
Secondary sale (non-resident buyer)	Sale price minus FMV at exercise	From exercise date	Same as buyback	Yes — FEMA NDI Rules + Form FC-TRS
M&A acquisition	Acquisition price minus FMV at exercise	From exercise date	12.5% LTCG if >24 months; slab rate if ≤24 months	Depends on acquirer residency
IPO (listed shares)	Sale price minus FMV at exercise	12 months for listed LTCG	12.5% LTCG if >12 months; 20% STCG if ≤12 months	No

ESOP vs RSU vs Phantom Stock: which instrument to use

Most Indian startup founders default to ESOPs without considering whether the instrument actually fits the situation. Three instruments cover the majority of equity compensation scenarios, and the tax and dilution treatment differs materially between them.

An ESOP (Employee Stock Option Plan) gives the employee the right to buy shares at a fixed exercise price after vesting. The perquisite tax at exercise applies on the spread between FMV and exercise price. The employee pays cash to exercise and becomes a shareholder. This is the right instrument for most Indian startups from Seed to pre-IPO, because the low exercise price creates meaningful upside, the DPIIT deferral is available, and investors understand and expect ESOPs on the cap table.

An RSU (Restricted Stock Unit) vests directly into shares with no exercise price. The employee pays nothing at vesting, but the entire FMV of the shares at vest is treated as perquisite income in the year of vesting and taxed as salary. The perquisite is higher because the denominator is zero (no exercise price offsets the FMV). RSUs are appropriate for listed companies or post-IPO, where the shares have immediate liquidity and employees can sell enough to cover the tax. For an unlisted startup, RSUs create the same liquidity trap as low-exercise-price ESOPs, with no design lever to reduce the perquisite.

Phantom Stock (also called Stock Appreciation Rights or SARs, when cash-settled) gives the employee a cash payment equal to the appreciation in share value between grant and payout date. No shares are allotted, no FEMA filing is required, and the employee never becomes a shareholder. The payout is taxed as salary income in full, with no capital gains treatment. Phantom stock is useful for non-resident employees where FEMA compliance on equity allotment is complex, or for consultants and advisors who cannot receive ESOPs under the Companies Act route. The absence of LTCG treatment is a significant long-term disadvantage for employees who have been with the company through substantial value creation.

Feature	ESOP	RSU	Phantom Stock
Employee pays to exercise	Yes (exercise price)	No	No
Perquisite basis	FMV minus exercise price	Full FMV at vest	Not applicable
Capital gains at exit	Yes (LTCG at 12.5% if >24 months)	Yes (LTCG if >24 months from vest)	No (all salary)
DPIIT deferral available	Yes (with IMB cert)	No statutory deferral	Not applicable
FEMA on allotment	Yes for NR employees	Yes for NR employees	No (cash settled)
Dilution to cap table	Yes	Yes	No
Best suited for	Seed to pre-IPO, resident employees	Listed co. or post-IPO	NR employees, advisors

Refresh grants: resetting retention incentive before it breaks

A founder who designed a four-year ESOP scheme in 2021 and has not revisited it by 2025 has a retention problem. Employees hired in year one are now approaching full vesting. Their unvested option count is approaching zero, which means the equity retention lever is disappearing at exactly the point when the employee has the most market value and the most competitive offers.

Refresh grants solve this. A refresh grant is a new ESOP grant issued to an existing employee, typically timed when the employee has 12 to 18 months of unvested options remaining on their original grant. The refresh restarts the retention clock with a new four-year (or shorter) vesting schedule, usually without a new one-year cliff (the cliff is often waived for refresh grants to experienced employees). The new grant is issued at the current FMV or current exercise price, so the exercise price is higher than the original grant, but the employee accepts this because the company’s valuation is also higher.

From a tax design standpoint, a refresh grant creates a new perquisite exposure at a new (higher) FMV. If the company’s valuation has risen substantially, the spread between exercise price and FMV on the refresh grant may be smaller than on the original grant (if the refresh exercise price is set closer to current FMV), which reduces the perquisite. The holding period clock for LTCG on the refresh grant shares starts fresh from the new exercise date.

Three practical points on refresh grants. First, they require a new grant letter and a board resolution referencing the original ESOP scheme (no new shareholder resolution is needed if the options come from the existing approved pool). Second, if the existing pool is exhausted, a new scheme with fresh shareholder approval is required, and a new MGT-14 must be filed. Third, refresh grants to any individual that would take their total cumulative grant above 1% of issued share capital at the time of grant require a separate special resolution under Rule 12(6)(b) of the Companies (Share Capital and Debentures) Rules 2014. Many founders are unaware of this 1% concentration rule, and it surfaces as a compliance gap at Series B or Series C due diligence.

ESOP Compliance : What to file when

ESOP compliance under the Companies Act is not a one-time event. It is a recurring obligation at each stage of the ESOP lifecycle. The filings that surface most frequently as due diligence gaps are the following.

Form MGT-14 must be filed with the Registrar of Companies within 30 days of the shareholders passing the resolution approving the ESOP scheme. The 30-day clock runs from the date of the resolution, not from the date of the first grant. Missing this deadline exposes the company to late filing fees on a per-day basis, and beyond 300 days, adjudication proceedings under Section 454 of the Companies Act can apply, with fines on the company and every officer in default. When the company adopts a new scheme (for example, ESOP Scheme 2024 following an earlier ESOP Scheme 2021), a fresh MGT-14 must be filed for the new scheme.

Form PAS-3 (return of allotment) must be filed within 30 days of each allotment of shares upon exercise. Every exercise event that results in shares being issued requires a PAS-3. Startups that run annual exercise windows and never file PAS-3 accumulate a significant compliance backlog that appears in the company’s public MCA records, and an investor’s legal counsel reviewing the MCA master data will flag it immediately.

Form SH-6 is not filed with the RoC but must be maintained as an internal statutory register. It records every grant (employee name, date, number of options, exercise price, vesting schedule), every vesting event, every exercise, and every lapse or forfeiture. An SH-6 that is years out of date is the single most common ESOP compliance failure Treelife encounters during due diligence support. It cannot be reconstructed accurately after the fact; it must be maintained contemporaneously.

Annual disclosure in the Directors’ Report is required under Rule 12(9) of the Companies (Share Capital and Debentures) Rules 2014. The directors’ report must disclose the total number of options granted, vested, exercised, and lapsed in the year, the exercise price, and the money realised from exercise. For private companies that file annual returns with the RoC, this disclosure forms part of the publicly available record.

Compliance event	Form	Deadline	Filed with
Shareholder resolution approving scheme	MGT-14	Within 30 days of resolution	RoC
Allotment of shares on exercise	PAS-3	Within 30 days of allotment	RoC
ESOP register maintenance	SH-6	Ongoing (not filed, maintained internally)	Internal
Annual directors’ report disclosure	Part of annual report	At time of AGM filing	RoC (via AOC-4)
FC-GPR for non-resident allotment	FC-GPR	Within 30 days of allotment	AD Bank / RBI

Ind AS 102 accounting: what goes on the P&L and why it matters at due diligence

Every company that prepares financial statements under Ind AS (mandatory for companies with net worth above ₹250 crore, listed companies, and companies that have raised foreign investment in most cases) must account for ESOPs under Ind AS 102 (Share-Based Payment). Companies still on Indian GAAP follow the ICAI Guidance Note on Accounting for Share-Based Payments (2020), which applies similar principles.

The core requirement: the fair value of the option on the grant date must be determined using an option pricing model (Black-Scholes is the most widely used; the binomial lattice model is an alternative). This is a different valuation from the FMV used for perquisite tax purposes. The grant date FMV of the option itself (not the underlying share) is computed and then amortised as a compensation expense in the P&L over the vesting period.

For a startup that grants 10,000 options with a four-year vesting schedule and a grant-date fair value of ₹300 per option, the total ESOP expense is ₹30 lakh, recognised at ₹7.5 lakh per year over four years. This expense reduces reported profitability but does not involve cash outflow. The corresponding credit goes to a “Share Options Outstanding” equity reserve, which converts to share capital and securities premium when the options are eventually exercised.

Three points matter for founders approaching a fundraise or due diligence. First, if ESOP expense has not been recognised historically, the financial statements understate employee costs and overstate EBITDA. An investor adjusting for this in a valuation model will recalculate EBITDA downward. Second, restating prior-year financials to include ESOP expense is time-consuming and can delay due diligence closure. Third, options that lapse unexercised do not result in a reversal of accumulated expense; the expense already recognised is retained in equity as a “reserve for lapsed options.” This is a common point of confusion for founders who expect the cost to disappear when employees leave.

For unlisted startups not yet on Ind AS, the ICAI Guidance Note applies and uses intrinsic value (FMV minus exercise price) as an alternative to fair value, which results in lower expense recognition for deep in-the-money options. Transitioning to Ind AS requires adopting the fair value model, which will typically increase ESOP expense and reduce reported profits for the transition year.

When a startup has non-resident employees (on an OCI card, foreign national, or Indian employees based abroad) the allotment of shares under an ESOP triggers FEMA obligations. The exercise price for non-resident employees must comply with FEMA (Non-Debt Instruments) Rules 2019, which require that shares not be issued at less than fair value. Form FC-GPR must be filed with the Authorised Dealer Bank within 30 days of allotment. Failure to file attracts compounding proceedings before the Reserve Bank of India.

Indian subsidiaries of foreign parents face an additional layer: employees of the Indian subsidiary may be covered under the parent company’s global ESOP scheme. A cash-settled SAR (Stock Appreciation Rights) structure avoids the FEMA allotment problem because no Indian shares are issued. The employee receives a cash payment equal to the appreciation in parent stock value. However, cash-settled SARs are treated as salary income in the year of payment, with no capital gains treatment or LTCG benefit, which makes them less tax-efficient for the employee at exit.

FAQs on ESOP Scheme Design in Indian Startup

Q: Can we grant ESOPs to advisors and consultants, not just employees?
A: Under Section 62(1)(b) and Rule 12 of the Companies Act, ESOPs can be issued to permanent employees and directors. Advisors who are not employees or directors cannot receive ESOPs under this route. DPIIT-recognised startups can issue ESOPs to advisors through the Section 62(1)(c) consultancy equity route, which has different compliance and tax treatment. Specifically, the advisory equity is taxed as fees or professional income when received, not as an employment perquisite. Treelife structures advisor equity separately from the main ESOP pool for this reason.

Q: What is the minimum vesting period allowed by law?
A: Rule 12(1)(b) of the Companies (Share Capital and Debentures) Rules 2014 requires a minimum of one year between grant and first vesting. This cannot be waived or reduced. The one-year cliff is a statutory floor.

Q: We are a DPIIT-recognised startup but do not have an IMB certificate. Can our employees still benefit from the deferral?
A: No. The perquisite tax deferral under Section 392(3) of the IT Act 2025 requires both DPIIT recognition and IMB certification as an eligible startup under Section 140 of the same Act. DPIIT recognition alone is insufficient. Approximately 3,700 out of 1.97 lakh DPIIT-recognised startups have this certification.

Q: Can we set the exercise price below the face value of shares?
A: The Companies Act does not permit shares to be issued below face value. The exercise price cannot be below the face value of the equity share (typically ₹10 per share for most Indian startups, or ₹1 per share for those who have sub-divided). Setting the exercise price at face value is common and legally valid.

Q: What is the holding period for unlisted ESOP shares to qualify for LTCG?
A: 24 months from the date of exercise (not grant or vesting). Shares held for more than 24 months from exercise qualify for LTCG at 12.5% without indexation. Shares held for 24 months or less are taxed at the employee’s income slab rate as STCG.

Q: Can the ESOP scheme include a provision for the company to buy back shares from employees periodically?
A: Yes. The scheme can include a buyback or liquidity programme clause, and the company can conduct periodic buybacks under Section 68 of the Companies Act, subject to the buyback limit (25% of paid-up capital and free reserves in a single financial year) and proper board and shareholder approvals. This is increasingly common among growth-stage startups that want to offer partial liquidity before an IPO.

Q: How is FMV determined for the perquisite tax calculation for unlisted companies?
A: FMV must be certified by a Category I Merchant Banker registered with SEBI, under Rule 3(8)(vi) of the Income Tax Rules. The valuation must not be older than 180 days from the date of exercise. A Chartered Accountant valuation is not acceptable for this purpose.

Q: What happens to unvested options when a company is acquired?
A: It depends entirely on the acceleration clause in the scheme document. Without an acceleration clause, unvested options continue to vest on the original schedule post-acquisition (usually with a replacement option issued by the acquirer). With a double-trigger acceleration clause, unvested options vest if the employee is terminated without cause within a specified period (typically 12 to 18 months) after the acquisition closing. Without any clause, the scheme and the acquisition agreement will determine the outcome. This is why having a well-drafted scheme document before the M&A conversation starts matters.

Q: Are ESOPs available to employees of wholly owned subsidiaries?
A: Yes. Rule 12 allows options to be granted to employees of the company’s holding company or subsidiary, whether in India or abroad. This is commonly used by Indian holding companies with operating subsidiaries, or by foreign parent companies granting options over parent stock to Indian subsidiary employees.

Q: Does the 60-month deferral window under the IT Act 2025 apply to existing options granted before 01 April 2026?
A: No. The 60-month window applies only to shares allotted on or after 01 April 2026. Shares allotted before that date continue under the 48-month deferral window of the IT Act 1961.

Q: What is the tax treatment if an employee joins a DPIIT-eligible startup mid-year and exercises options in the same Tax Year?
A: The eligibility for deferral is determined by the company’s status at the time of allotment, not at the time of exercise per se. If the company holds a valid IMB certificate at the time of allotment, the deferral is available to the employee. The company’s responsibility to deduct TDS is suspended for the duration of the deferral. The employee must maintain documentation of the allotment date, FMV at exercise, and company eligibility status.

Regulatory references:

• Section 62(1)(b), Companies Act 2013 statutory authority for ESOP issuance by companies with share capital
• Rule 12, Companies (Share Capital and Debentures) Rules 2014 – procedural requirements including minimum vesting period, exercise price, scheme content, and SH-6 register maintenance
• Rule 12(6)(b), Companies (Share Capital and Debentures) Rules 2014 – separate special resolution required for grants to an individual exceeding 1% of issued share capital
• Rule 12(9), Companies (Share Capital and Debentures) Rules 2014 – mandatory annual directors’ report disclosure
• Form MGT-14, Companies Act 2013 – RoC filing within 30 days of special resolution approving ESOP scheme
• Form PAS-3, Companies Act 2013 – return of allotment, filed within 30 days of each exercise allotment
• SEBI (Share Based Employee Benefits and Sweat Equity) Regulations 2021 – applicable to listed companies; compensation committee, shareholder resolution, disclosures
• Ind AS 102 (Share-Based Payment) – grant date fair value, Black-Scholes, expense amortisation over vesting period
• ICAI Guidance Note on Accounting for Share-Based Payments (2020) – applicable to companies on Indian GAAP
• Section 17(2)(vi), Income Tax Act 1961 / equivalent provision, IT Act 2025 – perquisite classification of ESOP exercise gain as salary income
• Rule 3(8) and Rule 3(9)(ii), Income Tax Rules 1962 – FMV determination methodology; Category I Merchant Banker requirement for unlisted companies
• Section 192(1C), Income Tax Act 1961 – perquisite tax deferral for eligible startups (applies to shares allotted before 01 April 2026; 48-month window)
• Section 392(3) read with Section 289(3), Income Tax Act 2025 – perquisite tax deferral for eligible startups (applies to shares allotted on or after 01 April 2026; 60-month window)
• Section 140, Income Tax Act 2025 – eligible startup definition; IMB certification requirement (successor to Section 80-IAC, IT Act 1961)
• Section 68, Companies Act 2013 – share buyback authority
• FEMA (Non-Debt Instruments) Rules 2019 – pricing norms and Form FC-GPR filing for share allotments to non-residents
• Rule 10D, Income Tax Act 1961 / successor provision – transfer pricing for cross-border ESOP structures involving Indian subsidiaries of foreign parents

External sources:

• Ministry of Corporate Affairs
• Income Tax India
• SEBI
• Reserve Bank of India
• Startup India / DPIIT