A S BANKA ADVISORS

Key Takeaways

• Granting ESOPs and having a legally sound ESOP are not the same thing. An option becomes real equity only when an approved scheme, a board grant, a valuation and a signed grant letter sit behind it. Everything else is a promise.
• Setting one up is a fixed sequence: size the pool, get the scheme approved by the board and the shareholders, set the vesting and exercise terms, get a defensible valuation, issue grant letters, and keep the records that prove all of it happened.
• ESOPs are taxed twice in India: as a perquisite (salary) when the employee exercises, and as capital gains when they sell. The capital-gains holding period runs from the date the shares are allotted, not the date of grant.
• Employees of a DPIIT-recognised eligible startup can defer the tax on exercise, broadly until 48 months after the end of the assessment year in which the shares were allotted, or the date they leave, or the date they sell, whichever is earliest.
• The reason to do the paperwork now is due diligence. A pool with missing approvals, no valuation or unsigned letters is precisely what an investor or acquirer finds, and it gets fixed under time pressure at the worst possible moment.

Most founders create their first ESOP in a hiring conversation. A candidate asks about equity, you say “we will give you options”, a number gets typed into an offer letter, and everyone moves on. Months later, when you learn how to set up an ESOP for an Indian startup properly, you discover the offer letter created an expectation and almost nothing else: no scheme the board approved, no valuation, no grant letter the employee actually signed. This article is the sequence that turns those promises into equity that holds up, in the order you should do it, and it flags the two places founders most often find out too late that the structure was never there.

Granting options is a promise. An ESOP is a structure.

An employee stock option gives someone the right to buy a fixed number of shares in your company, at a fixed price, after they have stayed and vested. For that right to mean anything, four things have to exist: a written scheme your company formally adopted, a board decision that granted the specific options to the specific person, a valuation that fixes what the shares are worth, and a letter the employee signed accepting the grant. Miss any one of them and what you have is an intention, not an option.

This is not pedantry. When your company raises, gets acquired, or an early employee tries to exercise and sell, someone reads the file. If the file is four promises in four offer letters with no scheme behind them, the options do not simply appear; they have to be reconstructed, re-approved and re-valued, retroactively, while a deal is waiting. The setup below is what keeps that from happening.

How to set up an ESOP for your Indian startup, step by step

Do these in order. Each one depends on the one before it.

1. Decide the pool size and why it exists. Your option pool is the total slice of the company reserved for employees. In practice most startups set aside a single-digit to low-double-digit percentage of the fully diluted cap table, sized to the hires you actually plan to make, not a round number. How the pool sits inside your cap table, and who pays for it when you raise, is its own subject; our note on ESOP architecture across funding rounds covers the sizing decision in depth. Decide this first, because everything after it grants out of this pool.
2. Get the scheme approved by the board and the shareholders. The ESOP scheme is a written document: who is eligible, how much is in the pool, how vesting works, what happens when someone leaves. For a private company this scheme has to be approved by your board and then by your shareholders before a single option is granted. This is the step founders skip most, because it feels like formality, and it is the step that makes every grant underneath it valid. An option granted before the scheme exists is granted out of nothing.
3. Set the vesting and exercise terms. Decide the vesting schedule (a four-year vest with a one-year cliff is the common shape, meaning nothing vests for the first year and then it accrues monthly or quarterly), the exercise price the employee pays per share, and the exercise window, including how long a leaver has to exercise what they have vested before it lapses. Set the exercise price deliberately: the gap between what the employee pays and what the share is worth on the day they exercise is exactly what they get taxed on, so a very low exercise price is generous on paper and a larger tax bill in the year of exercise.
4. Get a defensible valuation of your shares. You need a fair-market valuation of your company’s shares, dated close to the grant, for two reasons: it sets a defensible exercise price, and the value on exercise is what the employee’s perquisite tax is calculated against. A valuation done properly at grant, and refreshed as the company’s value moves, is cheap insurance. A grant with no valuation behind it is the single most common thing that has to be redone under diligence pressure.
5. Issue and countersign grant letters. Each employee gets a grant letter stating the number of options, the exercise price, the vesting schedule and the exercise window, referencing the approved scheme. The employee signs it. Unsigned grant letters are the quiet killer: the company thinks it granted, the employee thinks they were granted, and the file shows neither of them actually completed it.
6. Keep the records that prove it happened. Maintain the board and shareholder approvals, the scheme, the valuation, the signed grant letters, and a register showing who holds what and how much has vested. Your annual company filings should reflect that the scheme exists and how the pool has moved. The whole point of the earlier steps is that they leave a paper trail; keeping that trail in one place is what makes a diligence a morning’s work instead of a scramble.
7. Handle exercise and tax when the time comes. When an employee exercises, the company allots them shares and a tax event is triggered (covered in the next section). This is not a setup step so much as the moment the setup gets tested, and it is far smoother when steps one to six were done at the start rather than reconstructed now.

How ESOPs are taxed once your team exercises

There are two tax moments, and it helps to know them before you design the grant, because they change what “generous” actually costs your team.

At exercise, it is treated as salary. When the employee exercises and the shares are allotted, the difference between the fair market value of the shares on that date and the price the employee paid is taxed as a perquisite, in the same bucket as salary, in the year of exercise. That is why the exercise price and a proper valuation matter: they define the size of this number.

At sale, it is capital gains. When the employee later sells the shares, the gain over the value already taxed at exercise is taxed as capital gains. Importantly, the holding period that decides whether the gain is short or long term runs from the date the shares were allotted, not from the date the option was originally granted. Our detailed walk-through of how ESOPs are taxed for Indian startup employees takes both moments apart with worked examples.

There is relief for eligible startups. If your company is a DPIIT-recognised eligible startup, employees can defer the tax due at exercise. Broadly, the deferred tax becomes payable at the earliest of three events: 48 months after the end of the assessment year in which the shares were allotted, the date the employee leaves the company, or the date they sell the shares. This deferral exists precisely because the exercise-year tax bill on an illiquid private share is a real cash problem for employees, and it is one of the more valuable reasons to formalise your startup’s recognition status early.

Why unstructured ESOPs fall apart in due diligence

The payoff for all of this is not tidiness. It is what happens when someone with money and lawyers reads your cap table. In diligence, an investor or acquirer will ask for the scheme, the approvals, the valuations and the signed grant letters for every option outstanding. If those exist and agree with each other, ESOPs are a non-event in the process. If they do not, the pool becomes a problem to be cleaned up, often by re-approving grants, re-valuing shares and chasing signatures years after the fact, sometimes with employees who have since left. This is the same class of issue as the invisible gaps in a cap table that looks fine on the surface; our piece on why your cap table looks clean but isn’t covers where else founders lose ground here. The cheapest time to build the file is before anyone asks for it.

Frequently asked questions

How do I set up an ESOP for my Indian startup?

Set the pool size, get a written ESOP scheme approved by your board and shareholders, decide the vesting and exercise terms, obtain a fair-market valuation of your shares, issue grant letters that each employee signs, and keep the approvals, valuation, letters and a register on file. Do them in that order, because each step depends on the one before it.

Do I need shareholder approval to grant ESOPs?

Yes. For a private company the ESOP scheme has to be approved by the board and then by the shareholders before any option is granted. Options granted before the scheme is properly approved are the most common thing that has to be reconstructed and re-approved during due diligence.

How are ESOPs taxed in India?

Twice. At exercise, the difference between the fair market value of the shares and the price the employee paid is taxed as a perquisite, alongside salary, in the year of exercise. At sale, any further gain is taxed as capital gains, with the holding period counted from the date the shares were allotted.

Can my employees defer the tax on their ESOPs?

If your company is a DPIIT-recognised eligible startup, employees can defer the tax due at exercise. The deferred tax becomes payable at the earliest of three events: 48 months after the end of the assessment year of allotment, the date the employee leaves, or the date they sell the shares.

What happens to an employee’s ESOPs when they leave?

It depends on what your scheme says, which is why the terms matter. Typically, unvested options lapse on departure, and the employee has a defined exercise window to buy the shares they have already vested before those lapse too. If your scheme and grant letters do not spell this out, you will be negotiating it at the worst possible time.

The one thing to do this week

Open the file for every ESOP you believe you have granted and check each one for four things: an approved scheme, a board grant, a valuation, and a grant letter the employee signed. If any grant is missing one of the four, it is a promise, not an option, and it is far cheaper to complete it today than to reconstruct it while a term sheet is waiting.

Not sure whether the ESOPs you have handed out would survive a buyer’s diligence? That is exactly the kind of thing worth a proper look before you raise or sell, not during. You can book a slot through the link in the comments.

Disclaimer: This article is general information for founders and does not constitute legal, tax or financial advice. ESOP rules and their application depend on your company’s specific facts. Confirm the specifics of your scheme, valuation and tax position with your own advisers before you act.