ESOP Guide for Indian Founders

ESOP Guide for Indian Founders

Employee Stock Ownership Plans (ESOPs) are one of the most powerful tools for startups to attract and retain top talent. This guide covers everything from setting up an ESOP pool to tax implications for both the company and employees.

What are ESOPs?

ESOPs give employees the right to purchase company shares at a predetermined price (exercise price) after a specified period (vesting period). They align employee interests with company growth.

Setting Up an ESOP Pool

#### Step 1: Determine Pool Size

Typical ESOP pool: 10-15% of fully diluted equity

Pre-seed stage: 10% is standard

Series A: 12-15% is common (may need top-up)

Series B+: 15-20% including refresher grants

Note: Investors often require the ESOP pool to be set up or topped up before their investment (so the dilution comes from founders, not investors).

#### Step 2: Board and Shareholder Approval

Required resolutions:

Board resolution approving the ESOP scheme

Special resolution passed by shareholders (75% majority)

File MGT-14 with ROC within 30 days

#### Step 3: Create the ESOP Scheme Document

The scheme must include:

Total number of options to be granted

Eligibility criteria

Vesting schedule and conditions

Exercise price and exercise period

Lock-in period after exercise (if any)

Method of valuation

Vesting Schedules

The most common vesting structures in India:

Standard 4-Year Vesting with 1-Year Cliff:

Year 1: 0% (cliff period, nothing vests)

After Year 1: 25% vests immediately

Remaining 75%: Vests monthly or quarterly over next 3 years

Example: If an employee is granted 1,000 options:

After 12 months: 250 options vest

Month 13 onwards: ~21 options vest per month

After 48 months: All 1,000 options are vested

Other structures:

3-year vesting: Faster vesting for senior hires

Back-loaded vesting: More options vest in later years (e.g., 10%, 20%, 30%, 40%)

Performance-based vesting: Options vest upon achieving specific milestones

Exercise Price

The exercise price determines how much the employee pays to convert options into shares.

Common approaches:

Face value (INR 10): Most employee-friendly, maximum benefit to employee

Fair Market Value (FMV): No tax at exercise, gain only at sale

Discounted FMV: A middle ground

Important: The exercise price must be determined by a registered valuer as per Rule 11UA of Income Tax Rules.

Tax Implications

#### For Employees

At Exercise (Perquisite Tax):

The difference between FMV on exercise date and exercise price is taxed as salary income (perquisite)

Tax rate: As per employee's income tax slab (up to 30% + cess)

Employer must deduct TDS on this amount

At Sale (Capital Gains):

Short-term (held less than 2 years from exercise): Taxed at slab rates

Long-term (held more than 2 years from exercise): Taxed at 12.5% (after INR 1.25 lakh exemption)

Startup benefit (Section 80-IAC eligible startups):

Employees of DPIIT-recognized startups can defer perquisite tax for up to 4 years from exercise or until they leave the company or sell shares (whichever is earliest)

#### For the Company

ESOP grants are not a direct expense at grant time

The company must deduct TDS on perquisite value at exercise

ESOPs must be valued and disclosed in financial statements as per Ind AS 102

How Much ESOP to Give

Typical ranges by role and stage:

| Role | Seed Stage | Series A | Series B+ |

|------|-----------|----------|-----------|

| CTO / Co-founder level | 2-5% | 1-3% | 0.5-2% |

| VP / Director | 0.5-1.5% | 0.25-1% | 0.1-0.5% |

| Senior Engineer | 0.1-0.5% | 0.05-0.25% | 0.02-0.1% |

| Mid-level Employee | 0.05-0.15% | 0.02-0.1% | 0.01-0.05% |

| Junior Employee | 0.01-0.05% | 0.005-0.02% | 0.002-0.01% |

Common Mistakes to Avoid

Not setting up a formal scheme: Verbal promises are not enforceable

Granting too much too early: Keep reserves for future key hires

Not explaining value to employees: Employees should understand what their options are worth

Ignoring tax implications: Employees may face unexpected tax bills at exercise

No buy-back policy: Without liquidity events, ESOPs have limited perceived value

Forgetting to top up the pool: After each funding round, review if the pool needs expansion

Liquidity for ESOP Holders

Since startup shares are not publicly traded, consider these liquidity options:

Secondary sales: Allow employees to sell vested shares to incoming investors

Company buy-back: Company repurchases shares at fair value

ESOP buy-back programs: Periodic programs (e.g., annually) where company offers to buy vested options

IPO or acquisition: Ultimate liquidity event