ESOPs for Startups: How to Attract Talent Without Burning Cash
Hiring top talent is one of the biggest challenges for Indian startups. You are competing against well-funded companies, established corporations, and global tech firms, often with a fraction of their budget. Employee Stock Option Plans (ESOPs) level the playing field by allowing you to offer something that money alone cannot buy: a meaningful ownership stake in a company with high growth potential. This guide covers everything you need to know about designing, implementing, and managing an ESOP program that attracts and retains the talent your startup needs to succeed.
What Are ESOPs and How Do They Work?
An ESOP gives employees the option (not obligation) to purchase company shares at a predetermined price after completing a specified vesting period. The economic benefit comes from the difference between the exercise price (what the employee pays) and the actual value of the shares (which hopefully increases over time).
The ESOP Lifecycle
- Grant: The company grants a specific number of stock options to an employee at a set exercise price
- Vesting: Options vest over a defined period (typically 4 years with a 1-year cliff)
- Exercise: The employee pays the exercise price to convert vested options into actual shares
- Holding: The employee holds the shares, participating in future value appreciation
- Exit: The employee sells shares during an IPO, acquisition, or secondary sale to realize the gain
Simple Example
Consider an employee granted 1,000 options at an exercise price of Rs. 100 per share. After 4 years of vesting, the company's shares are valued at Rs. 1,000 each. The employee exercises all options by paying Rs. 1,00,000 (1,000 x Rs. 100) and receives shares worth Rs. 10,00,000 (1,000 x Rs. 1,000). The gain is Rs. 9,00,000, minus applicable taxes.
ESOPs are options, not shares. An employee does not own any shares until they exercise their vested options by paying the exercise price. Until exercise, the employee has no voting rights, dividend rights, or actual ownership in the company. The ESOP grants a right to purchase shares in the future, not the shares themselves.
Why ESOPs Are Essential for Startups
ESOPs solve several critical challenges that every growing startup faces.
| Challenge | How ESOPs Help |
|---|---|
| Cannot match big company salaries | Equity upside compensates for lower cash salary, creating higher total value if the company succeeds |
| High employee turnover | Vesting schedules (especially the 1-year cliff) create strong retention incentives |
| Misaligned incentives | Employees with equity think like owners, making decisions that benefit the company long-term |
| Cash burn concerns | Reduces the cash component of compensation, preserving runway for growth |
| Competing for scarce talent | Offers something unique that larger companies often cannot: significant ownership in a high-growth venture |
Setting Up an ESOP: Step-by-Step
Step 1: Determine the Pool Size
Decide what percentage of total equity to allocate to the ESOP pool. The typical range is 10% to 15% of total shares.
- Pre-seed/Seed stage: Start with 7% to 10%. You may need to expand later.
- Series A: Investors typically expect a 10% to 15% pool to be carved out before their investment
- Later stages: Pool may be topped up during subsequent funding rounds, with dilution shared between founders and investors
Step 2: Pass Required Resolutions
Under the Companies Act, 2013, the ESOP scheme must be approved by:
- A special resolution in the general meeting (75% majority of shareholders)
- Board resolution approving the scheme details
- Filing of Form MGT-14 with the Registrar of Companies
Step 3: Get Valuation
A registered valuer must determine the fair market value of the company's shares to set the exercise price. The valuation is also needed for tax purposes. Common valuation methods for startups include Discounted Cash Flow (DCF), Net Asset Value (NAV), and comparable company analysis.
Step 4: Design the ESOP Policy
Create a comprehensive ESOP policy covering all terms and conditions. Key elements include:
- Total pool size and authorized options
- Eligibility criteria (who can receive ESOPs)
- Vesting schedule and cliff period
- Exercise price and exercise window
- Good leaver vs bad leaver provisions
- Acceleration clauses (change of control, IPO)
- Lock-in periods, transfer restrictions, and buyback rights
Step 5: Issue Grant Letters
Each eligible employee receives an individual ESOP grant letter specifying the number of options, exercise price, vesting schedule, and other terms specific to their grant. The employee acknowledges and accepts the grant.
ESOP Taxation in India
Understanding the tax implications is critical for both the company and employees.
Tax Event 1: At Exercise
When an employee exercises their options, the difference between the Fair Market Value on exercise date and the exercise price is taxed as a perquisite (salary income).
| Component | Value |
|---|---|
| Fair Market Value at exercise | Rs. 1,000 per share |
| Exercise price paid by employee | Rs. 100 per share |
| Taxable perquisite per share | Rs. 900 |
| Total perquisite on 1,000 shares | Rs. 9,00,000 |
| Tax at 30% slab + cess | Approximately Rs. 2,81,000 |
Employees of DPIIT-recognized startups can defer the perquisite tax for up to 5 years from the end of the relevant assessment year, or until the shares are sold, or until the employee leaves the company, whichever is earlier. This removes the burden of paying tax on unrealized gains. Register under Startup India to enable this benefit for your employees.
Tax Event 2: At Sale
When the employee eventually sells the shares, capital gains tax applies on the difference between the sale price and the FMV at the time of exercise.
| Holding Period | Tax Category | Tax Rate |
|---|---|---|
| Less than 24 months (unlisted) | Short-term capital gains | At employee's income tax slab rate |
| 24 months or more (unlisted) | Long-term capital gains | 20% with indexation benefit |
| Less than 12 months (listed) | Short-term capital gains | 15% |
| 12 months or more (listed) | Long-term capital gains | 10% on gains exceeding Rs. 1 lakh (no indexation) |
ESOP Grant Framework: How Much to Give
One of the most challenging decisions is determining how many options to grant to each employee. Here is a practical framework.
| Role Level | Pre-Seed/Seed | Series A | Series B+ |
|---|---|---|---|
| CXO / VP (first hires) | 1% to 3% | 0.5% to 1.5% | 0.2% to 0.5% |
| Director / Senior Lead | 0.5% to 1% | 0.2% to 0.5% | 0.05% to 0.2% |
| Manager / Senior Engineer | 0.1% to 0.3% | 0.05% to 0.15% | 0.02% to 0.05% |
| Individual Contributor | 0.05% to 0.1% | 0.01% to 0.05% | 0.005% to 0.02% |
Earlier employees should receive larger ESOP grants because they are taking on more risk. An engineer joining at the seed stage is taking a bigger leap of faith than one joining after Series B, so their equity compensation should reflect this. The grant percentages naturally decrease as the company's valuation increases and the risk decreases.
Vesting Schedules: Designing for Retention
Standard 4-Year Vesting with 1-Year Cliff
This is the most common structure globally and in India:
- Month 0 to 12 (Year 1): No options vest (cliff period). If the employee leaves, they get nothing.
- Month 12: 25% of total options vest at once (cliff vesting)
- Month 13 to 48: Remaining 75% vest monthly (1/48th of total per month) or quarterly
- Month 48: 100% of options are fully vested
Alternative Vesting Structures
| Structure | How It Works | Best For |
|---|---|---|
| Back-loaded vesting | 10% year 1, 20% year 2, 30% year 3, 40% year 4 | Strong retention incentive for later years |
| Equal annual vesting | 25% at the end of each year | Simple, easy to understand |
| Milestone-based vesting | Vests upon achieving specific business targets | Performance-linked grants for key hires |
| Accelerated cliff | 6-month cliff instead of 1 year | Senior hires with proven track records |
Legal Compliance Requirements
The Companies Act, 2013 and the Companies (Share Capital and Debentures) Rules, 2014 govern ESOPs in India.
Key Legal Requirements
- Special resolution: The ESOP scheme must be approved by shareholders through a special resolution (75% majority)
- Minimum vesting period: Options must have a minimum vesting period of 1 year from the date of grant
- Registered valuer: A registered valuer must determine the exercise price and FMV
- Eligibility restrictions: Promoter directors and directors holding 10%+ equity cannot receive ESOPs
- Disclosure requirements: ESOP details must be disclosed in the Directors' Report and financial statements
- Accounting treatment: ESOP expense must be recognized over the vesting period as per Ind AS 102
- RoC filing: File Form MGT-14 for the special resolution and Form PAS-3 when shares are allotted upon exercise
Handling ESOPs During Key Events
During Funding Rounds
When raising investment, the ESOP pool is typically expanded or created before the new investment so that the dilution is borne by existing shareholders (primarily founders). Investors want to see a sufficient pool to attract future key hires. The unallocated pool is included in the fully diluted cap table but does not have voting rights until exercised.
During Acquisition
The acquisition agreement should address ESOP treatment. Common approaches:
- Cash-out: The acquirer pays option holders the difference between acquisition price and exercise price
- Assumption: Options convert into options of the acquiring company
- Acceleration: All unvested options vest immediately before the acquisition closes
During IPO
For an IPO, the ESOP scheme must comply with SEBI (Share Based Employee Benefits and Sweat Equity) Regulations, 2021. Existing ESOP plans may need restructuring. Post-IPO, employees can sell their vested shares on the stock exchange after any lock-in period (typically 6 to 12 months).
Communication and Employee Engagement
The effectiveness of an ESOP program depends heavily on how well it is communicated to employees.
What Employees Need to Understand
- What their options are worth: Share the current valuation, their percentage ownership, and potential future value under different scenarios
- Vesting timeline: A clear visual showing when options vest and what happens at each milestone
- Tax implications: Explain the two-stage taxation (at exercise and at sale) so there are no surprises
- Exit scenarios: When and how they can convert options to cash (IPO, acquisition, secondary sale, buyback)
- What happens if they leave: Clear explanation of good leaver vs bad leaver provisions and exercise windows
Create an ESOP dashboard or portal where employees can see their grant details, vesting progress, current estimated value, and key dates. Regular quarterly updates on the company's progress and valuation help employees understand and appreciate the value of their equity compensation. Transparency builds trust and reinforces the retention benefits of ESOPs.
Common ESOP Mistakes to Avoid
- Making verbal promises without documentation: Always use formal grant letters and a written ESOP policy. Verbal promises lead to disputes.
- Not explaining tax implications: Employees hit with unexpected tax bills at exercise lose trust. Educate them upfront.
- Setting the pool too small: Starting with 5% when you need 15% means expanding later, which requires additional shareholder approval and causes further dilution.
- Over-granting to early employees: Being overly generous with early hires can leave insufficient options for critical hires later.
- Ignoring valuation requirements: Grants without proper valuation create tax and legal issues. Always use a registered valuer.
- Unclear termination terms: Ambiguous good leaver/bad leaver definitions lead to legal disputes. Be specific in the policy.
Conclusion
ESOPs are one of the most powerful tools available to Indian startups for building a world-class team without exhausting their cash reserves. When designed properly, they create a culture of ownership where every employee is invested in the company's success. The key is getting the structure right from the start: appropriate pool size, clear vesting terms, proper legal compliance, transparent communication, and thoughtful tax planning.
At IncorpX, we help startups set up compliant ESOP programs as part of our company compliance and shareholder agreement services. From passing the necessary resolutions to filing with the RoC and getting proper valuations, we handle the legal and regulatory side so you can focus on using ESOPs to build the team your startup deserves.
Frequently Asked Questions
What is an ESOP?
An Employee Stock Option Plan (ESOP) is a compensation program that gives employees the right to buy company shares at a predetermined price (exercise price) after a specified vesting period. ESOPs allow startups to offer ownership stakes to employees, aligning their interests with the company's growth. Employees benefit when the company's valuation increases, as they can buy shares at the lower exercise price and profit from the difference.
Why should startups offer ESOPs?
Startups offer ESOPs for several strategic reasons: attracting top talent without high cash salaries, retaining key employees through vesting schedules, aligning employee interests with company success, building an ownership culture, reducing cash burn on payroll, competing with larger companies that offer higher salaries, and rewarding early employees who took the risk of joining an early-stage company.
How much of the company should be set aside for ESOPs?
Most startups allocate 10% to 15% of total equity for the ESOP pool. Early-stage startups may start with 7% to 10% and expand as needed. The ESOP pool size is typically negotiated during funding rounds, with investors expecting a sufficient pool to attract key hires. The pool is usually created before the funding round so that dilution from ESOPs is borne by the founders rather than the investors.
What is a vesting schedule?
A vesting schedule determines when employees earn the right to exercise their stock options. The most common schedule is 4-year vesting with a 1-year cliff. This means no options vest in the first year, then 25% vest at the 1-year mark, and the remaining 75% vest monthly or quarterly over the next 3 years. Vesting ensures employees stay with the company long enough to earn their full equity grant.
What is a cliff period in ESOPs?
The cliff is a minimum period an employee must work before any options vest. A 1-year cliff means that if an employee leaves before completing 1 year, they forfeit all their options. After the cliff, the first block of options (typically 25%) vests at once. The cliff protects the company from giving equity to employees who leave shortly after joining. Some companies use 6-month or even no cliff for senior hires.
What is the exercise price?
The exercise price (also called strike price) is the price at which the employee can purchase the company's shares when they exercise their options. For startups, this is usually set at the fair market value (FMV) of the shares at the time the options are granted, or at a nominal value (like Rs. 1 or Rs. 10). A lower exercise price means a higher potential gain for the employee when the company's value increases.
How are ESOPs taxed in India?
ESOPs are taxed at two stages in India: (1) At the time of exercise: the difference between the Fair Market Value (FMV) on the date of exercise and the exercise price is taxed as a perquisite (salary income) at the employee's slab rate. (2) At the time of sale: the difference between the sale price and the FMV at exercise is taxed as capital gains (short-term or long-term depending on holding period). For unlisted companies, shares held for 24+ months qualify as long-term.
What tax relief is available for ESOP holders in startups?
DPIIT-recognized startups enjoy a significant tax benefit on ESOPs. Under Section 80-IAC/ 191(2), eligible employees of recognized startups can defer the perquisite tax on ESOP exercise for up to 5 years from the end of the assessment year, or until they leave the company or sell the shares, whichever is earlier. This removes the burden of paying tax on paper gains before any actual sale. Startup India recognition is essential for this benefit.
Can ESOPs be offered to all employees?
Yes, ESOPs can be offered to any employee of the company. However, most companies strategically allocate ESOPs to key employees, early joiners, leadership team members, and hard-to-hire specialists. Under the Companies Act, ESOPs cannot be granted to promoter directors or directors holding more than 10% of the outstanding equity. The grant is typically based on role, seniority, and the employee's impact potential.
What is the difference between ESOPs and sweat equity?
ESOPs are options to purchase shares at a predetermined price after vesting. Employees pay the exercise price to buy the shares. Sweat equity shares are shares issued at a discount or for non-cash consideration (like intellectual property or value addition) to directors or employees. Sweat equity can be issued only after 1 year of company incorporation and requires special resolution. Both are governed by different provisions of the Companies Act.
What legal requirements must a startup follow to implement ESOPs?
To implement ESOPs, a company must: pass a special resolution in the general meeting approving the ESOP scheme, file the resolution with the RoC (Form MGT-14), comply with Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014, obtain valuation from a registered valuer, maintain a register of options granted, and disclose ESOP details in the Directors' Report and financial statements annually.
What should an ESOP agreement cover?
A comprehensive ESOP agreement should include: total pool size and authorized options, eligibility criteria for employees, vesting schedule and cliff period, exercise price and exercise window, good leaver vs bad leaver provisions, acceleration clauses (change of control, IPO), lock-in periods (if any), transferability restrictions, termination provisions, and tax obligations of the employee.
What happens to ESOPs when an employee leaves?
When an employee leaves, the treatment depends on the vesting status and leaver classification. Vested but unexercised options typically have an exercise window (30 to 90 days after departure). Unvested options are forfeited and return to the pool. Good leavers (resignation, retirement) may get extended exercise windows. Bad leavers (termination for cause) may forfeit all options including vested ones. These terms should be clearly defined in the ESOP agreement.
What is a good leaver vs bad leaver clause?
A good leaver is an employee who leaves under positive circumstances (voluntary resignation in good standing, retirement, medical reasons, or death). They typically retain their vested options and have a reasonable exercise window. A bad leaver leaves under negative circumstances (termination for cause, breach of employment terms, joining a competitor). Bad leavers may forfeit some or all of their options, including vested ones. These definitions should be clearly specified in the ESOP policy.
How do investors view ESOPs?
Investors generally view a well-structured ESOP pool positively because it shows the founders' commitment to building a strong team. VCs typically expect a 10% to 15% ESOP pool to be created before their investment (so the dilution comes from the founders' stake, not the investor's). Having an ESOP pool also reduces the need for high cash salaries, preserving cash for growth. Investors scrutinize the vesting schedules, allocation strategy, and remaining pool availability.
Can ESOPs be offered in an LLP?
No, ESOPs cannot be offered in an LLP because LLPs do not have share capital. ESOPs are a share-based compensation mechanism that only works in companies (Private Limited or Public Limited). If you are operating as an LLP and want to offer equity compensation, you would need to convert to a Private Limited Company first. This is one of the reasons many startups prefer the company structure.
What is ESOP acceleration?
ESOP acceleration is a provision that speeds up the vesting of unvested options upon specific trigger events. Single-trigger acceleration vests options upon a single event (like acquisition of the company). Double-trigger acceleration requires two events (acquisition plus termination of the employee). Acceleration protects employees in scenarios like company acquisition where their job might be at risk. Most modern ESOP plans include some form of acceleration clause.
How do ESOPs work during an acquisition?
During an acquisition, ESOPs are typically handled in one of these ways: accelerated vesting (all unvested options vest immediately), conversion (options convert to shares of the acquiring company), cash-out (the acquirer buys out all options at the acquisition price minus exercise price), or continuation (the acquirer assumes the ESOP plan). The specific treatment depends on the acquisition agreement and the ESOP policy terms.
What is phantom stock/SAR?
Phantom stock (or Stock Appreciation Rights) is a cash-based incentive that mimics ESOPs without actually granting equity. Employees receive a cash bonus equal to the increase in share value between the grant date and a specified future date. Advantages include no actual equity dilution, simpler administration, and no need for share transfers. Disadvantages include no actual ownership and higher cash outflow when triggered. It is useful for companies that want to offer equity-like incentives without diluting ownership.
How should startups determine ESOP grants for different roles?
ESOP grants typically follow a banding system based on seniority and role. A common framework: CXOs and VPs (0.5% to 2% each), Directors and Senior Engineers (0.1% to 0.5% each), Managers and Mid-Level (0.05% to 0.15% each), Junior employees (0.01% to 0.05% each). Early employees typically receive larger grants to compensate for higher risk. Grants should consider the employee's cash salary, market alternatives, and the company's stage and valuation.
What is the fair market value (FMV) of ESOP shares?
The FMV of ESOP shares must be determined by a registered valuer using a recognized valuation method. For unlisted companies, common methods include Discounted Cash Flow (DCF), Net Asset Value (NAV), and comparable transaction multiples. The FMV at the time of grant determines the exercise price, and the FMV at exercise determines the perquisite tax. The valuation should be done by a SEBI-registered valuer or a chartered accountant for unlisted companies.
Can founders grant themselves ESOPs?
Under the Companies Act, promoter directors and directors holding more than 10% of outstanding equity cannot receive ESOPs. This restriction exists because ESOPs are designed to benefit employees and align their interests with shareholders, while promoters are already shareholders. Founders who are promoters should structure their compensation through salary and dividends. Non-promoter directors holding less than 10% equity can receive ESOPs.
What is a buyback clause in ESOP agreements?
A buyback clause gives the company or existing shareholders the right to buy back exercised shares from employees, typically when the employee leaves. This is important for unlisted companies where there is no public market to sell shares. The buyback price is usually the FMV at the time of buyback. Some companies include a right of first refusal (ROFR) instead, requiring employees to offer shares to existing shareholders before selling to third parties.
How do ESOPs affect the company's financial statements?
Under Indian Accounting Standards (Ind AS), ESOPs must be recognized as an expense over the vesting period. The expense is calculated based on the fair value of the options at the grant date (using option pricing models like Black-Scholes). This is a non-cash expense that reduces reported profit. The corresponding credit goes to an equity reserve (Share Options Outstanding Account). Proper ESOP accounting requires annual disclosures in the financial statements.
What is a share option outstanding account?
The Share Options Outstanding Account is an equity reserve on the company's balance sheet that accumulates the ESOP expense recognized over the vesting period. When employees exercise their options, the balance in this account is transferred to share capital and securities premium account. If options lapse or are forfeited, the balance is transferred to the General Reserve. This ensures proper accounting treatment of the equity compensation.
How do ESOPs interact with the company's cap table?
ESOPs affect the cap table in several ways: the ESOP pool represents reserved but unissued shares that dilute all shareholders proportionally when exercised. The cap table should show the total ESOP pool, granted options, vested options, exercised shares, forfeited options, and available pool. During fundraising, investors look at the fully diluted cap table (including all ESOP options) to understand their actual ownership percentage.
What is the minimum vesting period for ESOPs in India?
Under Rule 12(6) of the Companies (Share Capital and Debentures) Rules, 2014, the minimum vesting period for ESOPs is 1 year from the date of grant. This means no options can vest before 1 year. However, there is no maximum vesting period prescribed by law. Most companies use 3 to 4-year vesting schedules with a 1-year cliff, which is both legally compliant and practically effective for retention.
Should ESOPs come with a lock-in period?
A lock-in period is optional but sometimes included to prevent employees from selling shares immediately after exercise. Listed companies often have a lock-in of 6 to 12 months. For unlisted startups, the practical lock-in is that there is no public market to sell shares until an IPO or acquisition. Some ESOP plans include an explicit lock-in of 1 to 3 years after exercise to ensure long-term alignment.
What are the common mistakes startups make with ESOPs?
Common ESOP mistakes include: not creating a formal ESOP policy and making verbal promises, setting the pool size too small (needing expansion later, which dilutes further), unclear vesting and termination terms leading to disputes, not explaining the tax implications to employees, over-granting to early employees leaving insufficient pool for future hires, not getting proper valuations (causing tax issues), and not accounting for ESOPs properly in financial statements.
How does ESOP taxation work for unlisted companies?
For unlisted companies, ESOP taxation works as follows: at exercise, the difference between FMV and exercise price is taxed as perquisite (salary income) at the employee's slab rate. For sale: if shares are held for 24+ months after exercise, long-term capital gains (LTCG) tax applies at 20% with indexation benefit. If held for less than 24 months, short-term capital gains (STCG) are taxed at the employee's slab rate. DPIIT-recognized startups can defer perquisite tax for up to 5 years.
What is the Section 80-IAC benefit for ESOP taxation?
Section 80-IAC provides income tax exemption for eligible startups for 3 consecutive years out of the first 10 years. While this benefit is for the company's profits, the related provision under Section 191(2) allows employees of DPIIT-recognized startups to defer the payment of TDS on ESOP perquisites. The employee can defer tax payment until the earliest of: 5 years from the end of the relevant assessment year, sale of shares, or leaving the company. Get DPIIT recognition here.
How should ESOPs be communicated to employees?
Effective ESOP communication should include: a clear written ESOP policy document, an individual grant letter specifying the number of options, exercise price, and vesting schedule, regular updates on the company's valuation and what the options are worth, an ESOP handbook explaining the mechanics (vesting, exercise, taxation), a cap table view showing the employee's percentage ownership, and accessible Q&A sessions addressing employee concerns about liquidity and tax treatment.
Can ESOPs be modified after granting?
Modifications to granted ESOPs require shareholder approval through a special resolution. Common modifications include repricing (changing the exercise price), extending the exercise window, accelerating vesting, or changing the pool size. Repricing is sensitive because it affects existing grantees and can have accounting implications. Any modification must be disclosed in the financial statements and may require fresh valuation by a registered valuer.
What happens to ESOPs during an IPO?
During an IPO, ESOPs typically undergo several changes: the ESOP pool is restructured to comply with SEBI (Share Based Employee Benefits) Regulations, a new ESOP scheme may be introduced for listed company requirements, existing unvested options may be accelerated or converted, a lock-in period of 6 to 12 months post-listing may apply to exercised shares, and employees can sell their vested and exercised shares on the stock exchange after the lock-in period. This is when ESOP holders realize the value of their equity.
How do ESOPs compare to other employee incentive programs?
ESOPs provide actual equity ownership, while other programs provide cash or deferred benefits. RSUs (Restricted Stock Units) are shares granted directly (not options) that vest over time. SARs (Stock Appreciation Rights) provide cash equivalent to share price appreciation. Profit-sharing plans distribute a percentage of profits to employees. Retention bonuses are one-time cash payments for staying through a period. ESOPs and RSUs create the strongest alignment with company growth but involve equity dilution.
