A startup in Gurugram promises its first ten engineers “equity” in their offer letters, and two years later discovers that nothing it wrote was a valid grant. An engineer resigns after three years and learns that his vested options lapse in thirty days unless he pays several lakh rupees to exercise them, plus tax on shares he cannot sell. A founder assumes he can give himself options and finds the law says otherwise. Stock options are one of the most valuable things a young company can offer, and one of the most frequently mishandled. This page explains how a plan is built, what the law requires, how it is taxed, and what each side should read before signing.
A stock option is a right, not a share. The company promises an employee that, after a period and subject to conditions, he may buy a stated number of its shares at a price fixed today. Until he exercises that right and pays the price, he owns nothing in the company: no vote, no dividend, no share certificate. If the shares become worth more than the price, the option is valuable. If they do not, he simply does not exercise it and loses nothing but the hope.
Four words describe the life of an option, and they appear in every scheme:
| Stage | What happens | What the employee has |
|---|---|---|
| Grant | The company awards options under its scheme, in a grant letter | A promise, subject to conditions |
| Vesting | The conditions — usually time, sometimes performance — are met | A right he can now exercise |
| Exercise | He applies to buy the shares and pays the exercise price | An entitlement to shares |
| Allotment | The company issues the shares to him | Shares, as a member of the company |
The gap between grant and exercise is the point. An engineer who joins a company valued modestly receives options priced at that value. If, four years later, the company is worth ten times as much, he can buy at the old price. The difference is his reward for having joined early and stayed.
That same gap is where the risks lie. The shares of a private company usually cannot be sold freely; exercising costs money and triggers tax; and the value exists only if there is eventually a buyer. An option plan that ignores these realities offers employees something that looks generous on paper and is worth little in practice.
This page uses “ESOP” in the way it is used in India: to mean the employee stock option scheme, the options granted under it, and, loosely, the shares that result. Where the difference matters, it says so.
Young companies use stock options for reasons that are easy to understand. They cannot match the salaries of large employers, and options let them offer a share in the upside instead. Options align employees with owners: people who will benefit from the company’s growth have reason to work for it. And vesting encourages people to stay, because unvested options are lost on leaving.
Options also have costs. Every option, when exercised, dilutes the existing shareholders. They require documentation, approvals, valuations and records, every year. They create tax obligations for the employer as well as the employee. And badly designed options can breed resentment: an employee who discovers that his options are nearly worthless, or cannot be exercised without borrowing, may feel misled.
Options are a poor fit where:
In such cases, a cash-settled plan — a phantom stock plan or a profit-linked bonus — may achieve the same alignment without making anyone a shareholder. Those are discussed later on this page.
Where options are the right tool, the rest of this page is about doing them properly: a scheme that complies with the law, is honest about what it offers, and is administered with records that will survive an investor’s due diligence.
For companies incorporated in India, the foundation is the Companies Act, 2013. When a company increases its subscribed capital by issuing further shares, section 62 requires them to be offered to existing shareholders unless one of the exceptions applies. One exception is an issue:
The conditions are prescribed in rule 12 of the Companies (Share Capital and Debentures) Rules, 2014. That rule defines who counts as an employee for the purpose, sets a minimum vesting period, prohibits transfer of options, provides for death and incapacity, lists what the explanatory statement to the shareholders must disclose, requires disclosures in the board’s report, and requires a register of options. The rest of this page follows those requirements.
Three other bodies of law sit alongside:
The company’s own documents matter too. The articles must permit the issue; the authorised capital must have room for the shares; and any shareholders agreement may require investor consent to the scheme or the pool size. Our shareholders agreement guide explains how such consents usually work.
The rules define “employee” for the purpose of stock options, and a grant to anyone outside the definition is not a valid grant under section 62(1)(b). Broadly, the definition covers:
It leaves out:
Two groups are frequently promised options and are not eligible. Consultants and advisers are not employees. A startup that wants to reward an adviser with equity must use a different route — a share issue at a fair price, sweat equity where its conditions are met, or a cash arrangement. And probationers, interns and contract staff may not be “permanent employees”; the scheme should define eligibility to match the rule, and grants should wait until the person qualifies.
Within the eligible group, the company decides who receives options and how many, through criteria set out in the scheme and applied by the board or its committee. Our employment agreement and offer letter services can make sure that what the offer letter says about options matches what the scheme can deliver.
Founders are usually promoters, and usually hold far more than ten per cent. Under the general rule, they cannot receive stock options. The reasoning is that options are meant to reward employees who are not already owners, and that promoters should not be able to dilute other shareholders by granting themselves cheap options.
The rules make an exception for startups. A company recognised as a startup under the Government’s startup notification has been permitted to grant options to promoters, and to directors holding more than ten per cent, for a period after incorporation. That period, originally shorter, has been extended to ten years. A founder in a qualifying startup can therefore hold options, subject to the scheme and the approvals. Our Startup India registration service handles the recognition.
Even where options are permitted, they are rarely the best tool for founders. Founders usually already hold shares, and the question for them is not how to acquire more but how their existing shares should vest if one of them leaves. That is dealt with by reverse vesting in a co-founder or shareholders agreement, not by options. Our co-founder agreement service drafts those terms.
Options for founders make most sense where an investor wants to top up a founder’s holding after dilution in a funding round, tied to future performance. In that case, the options must still be granted under an approved scheme, with the minimum vesting period and the other rules, and the investor’s consent will usually be required.
A company that ceases to qualify as a startup, or passes the ten-year mark, should not make new grants to promoters. Grants already made in compliance with the rule at the time are not affected by that change, but the point should be confirmed when it arises.
The pool is the total number of shares reserved for issue under the scheme. It is usually expressed as a percentage of the company’s fully diluted share capital — commonly somewhere between five and fifteen per cent for startups, though it depends on the company’s stage and hiring plans.
Three things decide the right size. Hiring plans: how many people, at what levels, will be offered options over the next two or three years. Investor expectations: investors often require a pool of a stated size to be created before they invest, so that existing holders, not the new investor, absorb the dilution. Refresh: existing employees whose options have vested may need new grants to keep them.
The pool must fit within the company’s authorised capital. If the authorised capital does not have room for the shares that may be issued on exercise, it must be increased by an ordinary resolution and a filing with the Registrar before the scheme is approved. Our authorised capital increase service handles this.
The pool should appear in the company’s cap table as a separate line, on a fully diluted basis. Investors will value the company on that basis, and a pool that does not appear, or appears at a different size in different documents, causes problems in every funding round.
A pool is a ceiling, not an obligation. Options that lapse or are forfeited usually return to the pool and can be granted again, if the scheme says so. The scheme should state whether the pool can be increased, and by what approval.
Get the scheme and resolutions drafted
An ESOP scheme passes through the board and then the shareholders.
The board approves the draft scheme and resolves to recommend it to the shareholders, convening a general meeting or, where permitted, a postal ballot. Where the company is required to have a nomination and remuneration committee, that committee usually administers the scheme. Our board resolution guide explains the board process, and our board resolution service drafts the resolutions.
The shareholders approve the scheme by special resolution. Private companies have been permitted, under an exemption notification, to approve such schemes by ordinary resolution. A separate resolution is required to grant options to identified employees, in any one year, equal to or exceeding one per cent of the issued capital, and to grant options to employees of group companies, as the rules provide.
The notice of the meeting must carry an explanatory statement giving the particulars the rules prescribe, which broadly include:
Where the resolution is a special resolution, it is filed with the Registrar within thirty days. The terms of a scheme already approved can be varied by special resolution, provided the variation is not prejudicial to employees who already hold options.
The scheme is the rulebook. Grant letters refer to it, and it governs wherever a grant letter is silent. It should be written to be read by employees, not just by lawyers, because employees are the people relying on it.
A typical scheme covers:
The scheme should be consistent with the articles and any shareholders agreement. An investor’s consent rights, drag-along and transfer restrictions will usually apply to shares issued on exercise, and employees should be told so. Where the documents conflict, employees are the ones who find out last.
Under the rules, at least twelve months must pass between granting an option and its vesting. Within that requirement, the company designs the schedule.
The most common pattern in startups is four-year vesting with a one-year cliff: nothing vests in the first year; at the first anniversary, a quarter of the options vest; the remaining three-quarters vest monthly or quarterly over the next three years. The cliff protects the company from rewarding someone who leaves in the first year, and it sits comfortably with the one-year minimum.
Other patterns include:
The scheme should state whether vesting continues during long leave, including maternity leave; the treatment of periods of secondment to a group company; and what happens to vesting on a change of role.
Vesting is a right, not a favour. Once options have vested according to the scheme, the company cannot take them away except on the grounds the scheme sets out, such as termination for defined misconduct. Employees should receive a vesting statement periodically, and at least when they leave.
For unlisted companies, the rules leave the exercise price to the company, subject to compliance with accounting standards. In practice, three approaches are used.
Fair market value at grant. The exercise price equals the value of a share at the date of grant, so that the option has value only if the company grows. This is the traditional design, and it is fairest to other shareholders.
A discount to fair market value. The exercise price is set below current value, giving the employee an immediate element of value. This increases the accounting cost and the tax on exercise.
Face value or a nominal price. Many Indian startups set the exercise price at the face value of the share, often one or ten rupees. The employee pays almost nothing to exercise, but the whole value of the share at exercise is taxed as a perquisite. That can leave an employee owing substantial tax on shares he cannot sell.
Valuation. An unlisted company needs a valuation of its shares for several purposes: to set the exercise price, to measure the accounting expense, and to compute the perquisite on exercise, where the tax rules require the fair market value on the exercise date to be determined by a qualified valuer as prescribed. Valuations should be updated at least annually and after each funding round. We draft the documents; the valuation is carried out by the valuer.
Whatever approach is chosen, the scheme and the explanatory statement must state the price or the formula, and every grant letter must state the actual price for that grant.
The grant letter is the document the employee actually receives and keeps. It should be complete enough to be understood on its own, and should refer to the scheme for everything else.
A good grant letter states:
An offer letter that promises “0.5 per cent equity” is not a grant. It is at most a promise to grant options in future, and it creates confusion about whether the percentage is of issued shares, fully diluted capital, or the pool. Offer letters should state a number of options, subject to a scheme, and the grant should follow promptly after joining.
Each grant must be recorded in the register of employee stock options, and the board or committee resolution approving grants should list them.
Once options have vested, the employee may exercise them within the exercise period. The steps are:
Some schemes allow exercise only at set windows during the year, or only on a liquidity event. The latter — sometimes called exercise on exit — means employees do not pay or incur tax until there is a buyer. It is attractive to employees but should be designed carefully with the vesting and exercise period rules.
Cashless exercise, where some of the shares are sold to pay the exercise price and tax, is practical mainly for listed companies or on a sale. For unlisted companies without a buyer, the employee usually needs cash.
Many private companies now have to hold their shares in dematerialised form, and newly allotted shares must then be credited through a depository. The company’s share records should be in order before the first exercise; our statutory registers service can help.
What happens to options when an employee leaves is the most important term in the scheme for employees, and the one they read least. It should be fair, clear and decided before anyone leaves.
Unvested options usually lapse on the date employment ends, and return to the pool. Some schemes give partial or accelerated vesting to employees whose employment ends without fault, such as in a restructuring.
Vested options can usually be exercised for a period after leaving. The rules require the explanatory statement to specify that period. Many schemes set a short window — thirty or ninety days — which forces a departing employee to decide quickly whether to pay the exercise price and the tax on shares he may not be able to sell for years. Increasingly, companies set longer windows, or allow exercise until a liquidity event, recognising that a short window can make vested options worthless in practice.
Good and bad leavers. Schemes often distinguish between leaving in good standing and leaving for cause. A “bad leaver” — dismissed for defined misconduct such as fraud, serious breach of confidentiality or joining a competitor in breach of contract — may lose even vested options. The rules allow the scheme to specify conditions under which vested options lapse, such as termination for misconduct, but the definition of misconduct must be precise and the process fair. A clause allowing the board to forfeit vested options at its discretion invites litigation.
Death. The rules provide that on the death of an employee, all options granted to him, vested or not, vest in his legal heirs or nominees. The scheme should give them a reasonable period to exercise, and explain the documents they will need.
Permanent incapacity. Where an employee suffers permanent incapacity while in employment, all options granted to him vest on the date of incapacity.
Retirement. Options commonly continue to vest, or vest immediately, on retirement in accordance with company policy.
The full and final settlement on leaving should include a statement of options vested, lapsed and exercisable, and the last date for exercise. Our termination and full and final documentation service prepares it.
Options are most valuable at an exit, and the scheme must say exactly what happens then.
Sale of the company. On a sale, the buyer may take over the scheme and convert the options into options over its own shares; the options may be cashed out, with employees receiving the difference between the sale price and the exercise price; or employees may be allowed to exercise immediately and sell their shares with everyone else. The scheme should give the board power to choose, within stated principles, and should treat all option holders in the same class equally.
Acceleration. Should unvested options vest on a sale? Single-trigger acceleration vests them on the sale itself. Double-trigger acceleration vests them only if the sale is followed by the employee’s termination without cause within a period. Double-trigger is more common, because buyers want key people to stay, and it protects employees from being dismissed by a new owner just before their options vest.
Drag-along. Shares issued on exercise are usually subject to the drag-along in the articles or shareholders agreement, so employees who hold shares can be required to sell on the same terms as the majority. Our shareholders agreement guide explains tag-along and drag-along.
Listing. On a listing, options become options over listed shares, and the rules applicable to listed companies and to employee schemes then apply. Pre-listing grants may be subject to lock-in requirements, and schemes are usually reviewed and ratified before an offer document is filed.
Corporate actions. Bonus issues, splits and consolidations change the number of shares. The scheme should adjust the number of options and the exercise price so that employees are neither better nor worse off.
The shares of an unlisted company usually cannot be sold freely. The articles of a private company restrict transfers; shareholders agreements add rights of first refusal and investor consents; and there may simply be no buyer. An employee who exercises options may therefore hold shares for years with no way to realise them.
Companies address this in several ways:
Each route must comply with the articles, the shareholders agreement and, where investors are foreign, foreign exchange pricing rules. Transfers of shares need proper instruments and stamp duty; our share transfer documentation service prepares them.
For employees, the practical lesson is to ask two questions before valuing options: how can I exercise without paying tax on shares I cannot sell, and when and how can I sell? A scheme that has clear answers is worth more than a larger grant under one that does not.
Stock options are taxed at two points, and understanding the first is what protects employees from surprises.
At grant and vesting, there is ordinarily no tax. The employee has only a right.
At exercise, the amount by which the shares’ fair market value on the exercise date exceeds what the employee pays is treated as a perquisite, taxable as salary in the year of exercise. The employer must deduct tax on it. For unlisted shares, the fair market value is determined by a valuer as the tax rules prescribe. If the exercise price is the face value of the share and the company has grown, the perquisite can be large, and the tax is payable in cash even though the shares cannot be sold.
Deferral for startups. For employees of eligible startups, tax on the exercise perquisite has been deferred until the earliest of: a set period after the end of the relevant assessment year; the date the employee sells the shares; or the date he ceases to be employed by the company. The deferral depends on the startup’s eligibility under the tax law, which is narrower than recognition as a startup for other purposes.
At sale, the gain over the fair market value on the exercise date is taxed as capital gains. The holding period runs from the date of allotment. For unlisted shares, the rates and the period after which a gain is long-term were changed in 2024, and should be checked when selling.
The employer’s side. The employer deducts tax on the perquisite and reports it in the employee’s salary statement. Where the employee does not fund the tax, the scheme should allow the employer to recover it, for example from salary or by withholding shares.
The Income-tax Act was re-enacted with effect from April 2026, and section references have changed. The treatment described here is the long-standing position; each employee and employer should confirm current rules with a chartered accountant. We do not give tax advice.
Stock options are not the only way to share value with employees. Each alternative has its place.
Stock appreciation rights. An employee receives the increase in value of a stated number of shares between grant and exercise, paid in cash or in shares. There is no exercise price to pay. Equity-settled rights involve issuing shares and follow share issue rules; cash-settled rights do not make the employee a shareholder.
Phantom stock. A cash bonus plan in which each “phantom share” pays out the value of a real share, or its growth, at a future date or event. No shares are issued, so there is no dilution and no need for shareholder approval under section 62, though the board should approve the plan and the company must fund the payment. The payment is taxed as salary when received. Phantom plans suit family companies and companies whose owners do not want employees on the register.
Sweat equity. Shares issued to employees or directors at a discount or for consideration other than cash, for providing know-how or value additions, under section 54 of the Companies Act. Sweat equity is issued outright, not as an option, and has its own conditions: a special resolution, a valuation, limits on the amount, and a lock-in. It can reward those who are not eligible for options in some cases, subject to its own definitions.
ESOP trusts. Some companies set up an employee welfare trust that holds shares for employees, acquiring them from the company or from shareholders, and transferring them to employees on exercise. Trusts can help with pooling, liquidity and administration, particularly for listed companies, where the securities regulator’s regulations govern them. For unlisted companies, a trust adds cost and complexity, and financial assistance by the company to the trust is itself regulated.
Choosing between these is a commercial and tax decision. The documentation follows the choice.
Many employees in India work for Indian subsidiaries of foreign companies and receive options over the foreign parent’s shares. Different rules apply.
Companies Act. The Indian subsidiary does not issue anything; the options are granted by the foreign parent under its own plan and its own law. Section 62 and rule 12 do not govern those grants.
Foreign exchange. Indian foreign exchange rules permit a resident employee or director of an Indian office, branch or subsidiary of a foreign company to acquire shares under an employee stock option or benefit scheme of that foreign company, subject to conditions, and to remit the exercise price. The Indian company often has reporting obligations in respect of such schemes.
Tax. The perquisite on exercise is taxable in India as salary, and the Indian employer usually deducts tax. The gain on sale is taxable in India as capital gains, and may also be taxed in the other country, with relief under a tax treaty where available. Resident taxpayers must disclose foreign shares in the foreign asset schedule of their tax return, even if they have not been sold; failure to do so carries penalties.
Recharge. Where the foreign parent charges the Indian subsidiary for the cost of options granted to its employees, the arrangement raises transfer pricing and foreign exchange questions for the company.
Employees with foreign parent options should keep grant letters, exercise confirmations and broker statements, and take advice from a chartered accountant familiar with cross-border compensation.
An ESOP is not a one-time document; it is a process that must be recorded every year. Investors’ due diligence teams check these records closely.
Register of employee stock options. The company must maintain a register in Form SH-6, recording each grant, the number of options, exercise price, vesting, exercise, lapse and the shares allotted. It should be kept at the registered office and updated with each event.
Board’s report. The rules require the board’s report each year to disclose details of the scheme, including options granted, vested, exercised and lapsed, the exercise price, any variation of terms, money realised on exercise, options in force, and details of grants to key managerial personnel and to employees who received options above specified thresholds.
Resolutions and filings. The board and shareholder resolutions approving the scheme, resolutions approving grants and allotments, the filing of special resolutions, and returns of allotment after each exercise.
Accounting. Options are a form of employee compensation. Under the applicable accounting standards, the fair value of options is recognised as an expense over the vesting period. That requires an option valuation at grant, not just a share valuation. Auditors will ask for it.
Employee communications. Grant letters, acceptances, vesting statements and exercise confirmations, with copies on file.
A company that has granted options informally for years — promised in offer letters, tracked in a spreadsheet, never approved — will need a clean-up before a funding round: a scheme, ratifying resolutions, formal grants replacing the informal promises, and a register. It is easier to do this early than under an investor’s deadline. Our statutory registers and minutes service can bring the records up to date.
Many Indian startups reach their first serious funding round with a history of informal promises: an offer letter that says “1% ESOP”, an email from a founder promising “some equity” to an early engineer, a spreadsheet of who was told what. None of these is a grant under the Companies Act, but each is a promise that someone relied on.
Cleaning this up is a sequence, not a single document:
Done openly, this usually strengthens trust. Employees who were uncertain what their “equity” meant receive a document that says exactly what they have. Done badly — by offering less than was promised without explanation — it produces the disputes it was meant to prevent.
Investors in a funding round, and buyers in an acquisition, review the ESOP closely, because options affect the share count they are buying into and the people they are relying on. Their checklist is predictable:
Gaps do not usually kill a deal, but they cost time and money, and they may require founders to give indemnities. A company that keeps its ESOP records in order from the first grant spends an afternoon on this part of diligence rather than a month.
Options are part of your pay. Before accepting a job offer that includes them, or signing a grant letter, ask:
Keep every document: the offer letter, the scheme, the grant letter, your acceptance, vesting statements and exercise papers. If a dispute arises about options promised or forfeited, a formal demand is usually the first step; our legal notice service drafts one. Litigation is for your advocate, engaged and paid by you directly; we do not quote, collect or share that fee. Our find an advocate page explains how to choose one.
A software startup in Gurugram has two founders and eight employees, and is about to raise a seed round. Its offer letters promised early employees “equity to be decided”. The investor requires a pool of ten per cent on a fully diluted basis, created before its investment.
The company increases its authorised capital, then adopts a scheme: a pool of ten per cent; eligibility limited to permanent employees and non-independent directors; four-year vesting with a one-year cliff; an exercise price at fair market value determined by a valuer; a vested-option exercise window of five years after leaving for good leavers and immediate lapse for dismissal for defined misconduct; double-trigger acceleration on a sale; and exercise permitted at any time after vesting.
The board approves the scheme; the shareholders approve it by resolution with the explanatory statement; the investor consents under its term sheet. The company then issues grant letters to the eight employees, with vesting credited from their joining dates, subject to the one-year minimum from grant, replacing the vague offer-letter promises. Each grant is entered in the register. The founders do not take options; their own shares are made subject to reverse vesting in the shareholders agreement.
At the investor’s due diligence three months later, the ESOP section takes an afternoon rather than a month.
An engineer in Bengaluru holds four thousand options at an exercise price of ten rupees, granted three years ago under a four-year plan. Three thousand have vested. The latest valuation puts each share at four hundred rupees. He has a job offer elsewhere.
He reads the leaver clause first. His scheme gives good leavers ninety days to exercise vested options. Exercising all three thousand would cost thirty thousand rupees, but would create a perquisite of nearly twelve lakh rupees, taxed as salary in that year, on shares he cannot sell. The company is an eligible startup, so tax on the perquisite would be deferred — but only until he leaves, which is now.
He asks the company whether he may exercise part, and whether it runs a buyback or secondary sale. It does not. He exercises a portion he can afford, lets the rest lapse, and delays his start date by two months so that more options vest first. A year later, the company is acquired; his shares are bought at a price well above the valuation, and he pays capital gains tax on the difference.
Had his scheme allowed exercise until a liquidity event, he could have kept all three thousand options without paying anything until the sale. That is the difference a leaver clause makes.
ESOP documentation is ₹6,999 and usually takes 5 – 15 days. We draft the scheme and the corporate documents; we are not valuers, merchant bankers or chartered accountants, and we do not advise on pool size or pricing as a financial matter.
| What is included | Why it matters |
|---|---|
| A discussion of your plan, eligibility and investor terms | A scheme that fits your company and your cap table |
| The ESOP scheme document | Compliant with section 62(1)(b) and rule 12, and readable by employees |
| Board resolution and shareholders’ resolution with explanatory statement | A valid approval, with the prescribed disclosures |
| Template grant letter and employee acceptance | Grants that replace vague promises |
| Vesting statement, exercise application and allotment resolution templates | The process ready for the first exercise |
| Compliance checklist for register, filings and board’s report | Records that survive due diligence |
Registrar fees and stamp duty are at actuals, and we tell you the total before we start. Valuation and tax advice are for your valuer and chartered accountant. Disputes before a court, tribunal or arbitrator are for your advocate, whose fee is engaged and paid by you directly; we do not quote, collect or share it.
A stock option plan is only as good as its paperwork and its fine print. Approve a scheme, issue real grant letters, keep the register, and think hard about what happens when people leave — because a vested option that must be exercised in thirty days, with tax on unsellable shares, is worth little. Tell us about your company, your team and your investors. We will draft a scheme and the approvals that employees can trust and investors can check.
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