ESOP Policy for an Indian Private Company: Approvals, Vesting, Exercise and Tax

An employee stock option plan (ESOP) lets you pay part of a team's reward in ownership. For an unlisted Indian company the framework is Section 62(1)(b) of the Companies Act, 2013 and rule 12 of the Companies (Share Capital and Debentures) Rules, 2014. Listed companies follow SEBI's share-based employee benefits regulations instead — this article is about private companies.

What the rules require

• Shareholder approval by special resolution, with the disclosures listed in rule 12 in the explanatory statement (total options, eligibility, vesting, exercise price or formula, exercise period, lock-in if any, and so on).
• A minimum gap of one year between the grant of an option and its vesting.
• Eligibility: permanent employees and directors (whole-time or not), and employees of a subsidiary or holding company, but not independent directors. Promoters, people in the promoter group and directors who, alone or with relatives or bodies corporate, hold more than 10% of the equity are excluded — except that an eligible startup (as defined by the government notification) can grant options to promoters and such directors for a period after incorporation. Check the current definition and the period before granting.
• Options cannot be transferred, pledged or mortgaged, and lapse or are dealt with according to the scheme on leaving.
• A register of options in the prescribed form (SH-6) and disclosures in the board's report.

The choices you control

Pool size

Founders and investors agree the pool, usually as a percentage of fully diluted capital, and investors often ask for it to be created before their money comes in so that existing shareholders bear the dilution. Agree how the pool is refreshed.

Vesting

Annual or monthly vesting after a one-year cliff is common; a one-year cliff also satisfies the statutory one-year minimum. Performance-linked vesting is possible but must be defined clearly enough to administer.

Exercise price and window

Options may be granted at face value, at a discount, or at fair value. A low exercise price makes the option more valuable but increases the taxable perquisite at exercise. The exercise window after vesting — and especially after an employee leaves — matters a great deal: a 30- or 90-day post-exit window forces a departing employee to pay the exercise price and tax quickly, often before there is any liquidity.

Leavers and corporate actions

Define good and bad leavers, what happens to unvested and vested options in each case, and how options adjust on bonus issues, splits, mergers and a sale (including any acceleration). Silence here produces disputes at exactly the wrong time — during a transaction.

How employees are taxed

Under the Income-tax Act, 1961 (and the corresponding provisions of the Income-tax Act, 2025 in force from 1 April 2026 — confirm current section numbers), the difference between the fair market value of the share on the date of exercise and the exercise price is taxed as a perquisite in the year of exercise, and the employer deducts tax at source through payroll. When the employee later sells, the gain over that fair market value is a capital gain.

For employees of eligible startups (those certified for the startup tax incentive), tax on the perquisite has been deferrable — payable within a set period after the end of the year, or on sale or leaving, whichever is earliest. Check whether your company qualifies and the current conditions before promising this in an offer letter.

Because the perquisite is taxed before the employee can sell, many companies offer a cashless exercise or a periodic buy-back or secondary window. If you plan buy-backs, remember the company's own buy-back conditions under Section 68.

Implementing it

1. Board approves the scheme and the draft notice; shareholders pass the special resolution.
2. Issue grant letters stating number of options, exercise price, vesting schedule and the scheme's leaver terms.
3. Maintain the SH-6 register and track vesting and exercise in payroll for tax.
4. On exercise, allot shares, file the return of allotment and update the cap table.

Use the ESOP sheet in the checklist workbook to review a draft scheme clause by clause.

Worked example: tax at exercise (illustrative)

An employee holds 1,000 vested options with an exercise price of ₹10. When she exercises, a registered valuer's report puts the fair market value at ₹210 per share. The perquisite is (₹210 − ₹10) × 1,000 = ₹2,00,000, taxed as salary in the year of exercise, and she pays ₹10,000 to the company as the exercise price. If she sells two years later at ₹400 per share, her capital gain is (₹400 − ₹210) × 1,000 = ₹1,90,000. Without a sale or buy-back, she has paid tax and the exercise price with no cash coming in — which is why the exercise window and any liquidity route matter so much in the policy.

Common mistakes

• Grant letters issued before the special resolution is passed.
• A vesting schedule with any part vesting within one year of grant.
• Options promised to a founder-director holding more than 10% when the company is not an eligible startup.
• No valuation on the exercise date, so payroll cannot compute the perquisite and TDS.
• A 30-day post-exit exercise window that departing employees cannot realistically use.
• The cap table and the SH-6 register not updated after exercises.