TL;DR: An ESOP (Employee Stock Option Plan) gives employees the right to buy shares in their company at a fixed price after a vesting period, letting them share in the company’s growth. In India, ESOPs are governed by Section 62(1)(b) of the Companies Act, 2013 and require a special resolution of shareholders, not just a board decision. They are taxed twice: as a salary perquisite when the employee exercises the options, and as capital gains when the shares are sold. Employees of DPIIT-recognised startups with an 80-IAC certificate can defer the perquisite tax, which solves the biggest problem with ESOPs: owing tax on shares you cannot yet sell. This guide explains how ESOPs work, the legal process, the tax, and the mistakes that derail them.
Quick overview: ESOPs have become the standard way Indian startups attract and retain talent they cannot afford to pay fully in cash. For employees they can be life-changing, or worthless, depending on the company’s outcome and how the plan is structured. For companies they are a powerful tool that is easy to get legally wrong: the most common mistake is approving ESOPs through a board meeting when the law requires a shareholder special resolution. This guide covers the ESOP lifecycle, the exact legal steps to set one up in India, how the tax works at each stage, the startup tax deferral, and what both sides should watch for.
What is an ESOP?
An ESOP, or Employee Stock Option Plan, is a scheme through which a company grants its employees the option to buy its shares at a predetermined price, called the exercise price or strike price, after they complete a defined vesting period. The employee is not obliged to buy: they have the option to, usually once the shares are worth more than the exercise price.
The logic is alignment. By giving employees a stake in the company’s equity, an ESOP ties their financial upside to the company’s success, which is why ESOPs are so common in startups and technology companies, where cash is scarce but growth potential is high. An employee who might command a higher salary elsewhere accepts a lower cash package in exchange for options that could be worth far more if the company succeeds.
ESOPs are one part of a startup’s equity structure, alongside founder equity and investor shares. Understanding how they fit with the overall cap table and fully diluted ownership is essential, because every ESOP grant dilutes existing shareholders, and the size of the ESOP pool is itself a point of negotiation with investors.
The ESOP lifecycle: grant, vest, exercise, sell
An ESOP moves through four stages, and understanding them is the key to understanding both the mechanics and the tax.
Grant is when the company awards options to an employee, setting out how many options, the exercise price, and the vesting schedule. No tax arises at grant.
Vesting is the period the employee must wait, and the conditions they must meet, before the options become exercisable. Indian law requires a minimum vesting period of one year from the grant date. Vesting is often spread over several years, sometimes with a one-year “cliff” (nothing vests until the first anniversary, then vesting occurs monthly or quarterly). No tax arises at vesting.
Exercise is when the employee chooses to buy the vested shares at the exercise price. This is the first taxable event: the difference between the fair market value of the shares and the exercise price is taxed as a salary perquisite.
Sale is when the employee eventually sells the shares. This is the second taxable event: any gain over the fair market value at exercise is taxed as capital gains.
How to set up an ESOP in India: the legal process
This is where companies most often go wrong, so it is worth setting out precisely. An ESOP in India is not something a founder can simply decide to grant.
The legal basis is Section 62(1)(b) of the Companies Act, 2013. Every ESOP grant draws its authority from an ESOP scheme adopted under this provision. Options granted without a valid scheme have no legal standing.
A special resolution is required. The ESOP scheme must be approved by the shareholders through a special resolution, meaning a 75% majority, not merely a board resolution. This is the single most common mistake: founders approve ESOPs in a board meeting, not realising the Companies Act mandates a shareholder special resolution. The error surfaces later, usually during investor due diligence, and has to be retrospectively regularised.
The resolution must be filed with the Registrar of Companies. Form MGT-14 must be filed with the RoC within 30 days of passing the special resolution. When options are exercised and shares allotted, Form PAS-3 must also be filed within 30 days of allotment. Missing these filings is a frequent compliance gap.
Valuation must be done properly. The shares must be valued by a registered valuer under the Companies Act, and for tax purposes, the fair market value is determined under Rule 11UA of the Income Tax Rules, often by a merchant banker. Issuing options without proper valuation leads to tax disputes later when employees exercise.
The promoter and 10% rule. Rule 12 of the Companies (Share Capital and Debentures) Rules generally prohibits granting ESOPs to promoters or to directors who hold more than 10% of the equity. There is an important exception: DPIIT-recognised startups can grant ESOPs to promoters and directors for up to 10 years from the date of incorporation. Founders who assume they can allocate ESOPs to themselves without qualifying for this exception create invalid grants.
For listed companies, ESOPs are additionally governed by the SEBI (Share Based Employee Benefits and Sweat Equity) Regulations, 2021.
Because these steps intersect with the company’s constitution and its investors’ rights, an ESOP scheme should be set up consistently with the shareholders’ agreement and the company’s broader startup legal compliance position.
How ESOPs are taxed in India
ESOP taxation is two-stage, and the timing of the first stage is what causes the most difficulty for employees.
Stage 1: perquisite tax at exercise. When an employee exercises their options, the difference between the fair market value (FMV) of the shares on the exercise date and the exercise price they pay is treated as a salary perquisite under the Income Tax Act. It is added to their salary income and taxed at their applicable slab rate, up to around 31.2% at the highest slab. The employer deducts this as TDS.
The problem is cash flow. For an unlisted startup, the employee now owes tax on a paper gain, the FMV minus the exercise price, even though they cannot sell the shares to raise the cash to pay it. Many employees face a real tax bill on shares they cannot yet turn into money.
Stage 2: capital gains at sale. When the employee later sells the shares, the gain over the FMV at exercise (which becomes their cost of acquisition) is taxed as capital gains. Following the Budget 2024 changes effective 23 July 2024, short-term capital gains on listed shares are taxed at 20%, and long-term capital gains are taxed at 12.5% on gains exceeding Rs 1.25 lakh. For unlisted shares, the holding period and rates differ, with the long-term threshold being 24 months rather than 12. The holding period for capital gains starts from the exercise (allotment) date, not the grant or vesting date.
The startup tax deferral: the relief that solves the cash-flow problem
To address the cash-flow problem at exercise, the government introduced a deferral for employees of eligible startups.
Employees of DPIIT-recognised startups that also hold a Section 80-IAC certificate (now Section 140 under the Income Tax Act, 2025) can defer the perquisite tax. Instead of paying at exercise, the tax becomes payable at the earliest of three events: 48 months from the end of the assessment year in which the shares were allotted (extended to 60 months for shares allotted on or after 1 April 2026 under the new Income Tax Act, 2025), the date the employee sells the shares, or the date the employee leaves the company.
There is a crucial catch that catches many people out. The deferral requires both DPIIT recognition and a valid 80-IAC certificate from the Inter-Ministerial Board. DPIIT recognition alone is not enough. As of 2026, only around 3,700 of nearly two lakh DPIIT-recognised startups hold the 80-IAC certificate, which means the great majority of startup employees do not actually qualify for the deferral, even though their employer is “a startup.” Anyone relying on this relief should confirm the company holds the certificate, not just DPIIT recognition.
What ESOPs mean for employees: questions to ask
If you are an employee being offered ESOPs, the grant letter is only the start. The questions that determine whether your options are valuable are often not answered in the offer.
Ask about the vesting schedule and cliff, the exercise price, and, critically, what happens to your vested and unvested options if you leave, which is often the harshest term in the plan. Ask whether there is a cashless exercise mechanism or a company buyback, because without one you may face a tax bill at exercise with no way to fund it. Ask whether the company holds the 80-IAC certificate that enables tax deferral. And ask about the current fair market value and the size of the option pool, so you can estimate what your grant is actually worth on a fully diluted basis.
The interaction with your employment contract matters too, particularly the leaver provisions and any non-compete or non-solicit terms that could affect your options if you move to a competitor.
Common ESOP mistakes companies make
Several errors recur, and each is avoidable.
Approving the ESOP by board resolution instead of the required shareholder special resolution. Granting options to promoters or 10%-plus holders without qualifying for the DPIIT startup exception. Issuing options without a proper registered-valuer valuation, creating tax disputes at exercise. Missing the MGT-14 filing within 30 days of the resolution, or the PAS-3 filing within 30 days of allotment. Setting no cashless exercise or buyback mechanism, so employees let valuable options lapse rather than face a tax bill on illiquid shares. And drafting the plan inconsistently with the company’s investor agreements and cap table, creating problems at the next funding round.
Investors increasingly scrutinise ESOP documentation, valuation reports, and MCA filings during due diligence, and gaps here can lead to conditional funding or a forced clean-up. Getting the plan right at the outset is far cheaper than regularising it under the pressure of a live round.
Frequently asked questions
What is an ESOP in simple terms?
An ESOP (Employee Stock Option Plan) gives employees the right to buy shares in their company at a fixed price after completing a vesting period. If the company grows and the shares become worth more than the fixed exercise price, the employee can buy at the lower price and benefit from the difference. ESOPs are used mainly by startups and technology companies to attract and retain talent by giving employees a stake in the company’s success.
How are ESOPs taxed in India?
ESOPs are taxed at two stages. At exercise, the difference between the fair market value of the shares and the exercise price is taxed as a salary perquisite at the employee’s slab rate (up to around 31.2%), with the employer deducting TDS. At sale, any gain over the fair market value at exercise is taxed as capital gains. Following the July 2024 changes, listed shares attract 20% short-term or 12.5% long-term capital gains tax, with different thresholds for unlisted shares.
Can startup employees defer ESOP tax in India?
Yes, but only if the startup qualifies. Employees of DPIIT-recognised startups that also hold a Section 80-IAC certificate (Section 140 under the Income Tax Act, 2025) can defer the perquisite tax until the earliest of 48 months from the end of the relevant assessment year (60 months for allotments from 1 April 2026), the sale of the shares, or leaving the company. Crucially, DPIIT recognition alone is not enough: the company must hold the 80-IAC certificate, and only a small fraction of DPIIT-recognised startups do.
What is the legal process to issue ESOPs in India?
ESOPs are issued under Section 62(1)(b) of the Companies Act, 2013. The company must adopt an ESOP scheme approved by a shareholder special resolution (75% majority), not just a board resolution, and file Form MGT-14 with the Registrar of Companies within 30 days. Shares must be valued by a registered valuer, a minimum one-year vesting period applies, and when options are exercised, Form PAS-3 must be filed within 30 days of allotment. Listed companies are additionally governed by SEBI regulations.
Can founders give ESOPs to themselves?
Generally no. Rule 12 of the Companies (Share Capital and Debentures) Rules prohibits granting ESOPs to promoters or to directors holding more than 10% of the equity. The exception is DPIIT-recognised startups, which can grant ESOPs to promoters and directors for up to 10 years from incorporation. Founders who allocate ESOPs to themselves without qualifying for this exception create invalid grants that cause problems in due diligence.
What happens to my ESOPs if I leave the company?
It depends on the plan, and this is one of the most important terms to check. Typically, vested options may be exercisable within a limited window after leaving, while unvested options usually lapse. Some plans have “good leaver” and “bad leaver” provisions that treat departures differently depending on the circumstances. Because the leaver terms can significantly affect the value of your grant, they should be understood before accepting an ESOP offer and are best read alongside your employment contract.
Authored and reviewed by Prakhar Rai, Advocate, founder of My Legal Pal. Prakhar is enrolled with the Bar Council of India and has over ten years of experience advising startups, founders, and companies on equity structuring, ESOPs, and commercial matters. He is an alumnus of the National Law School of India University, Bangalore, where he completed his Master of Business Laws, and of La Martiniere. Connect on LinkedIn.
This article is general information about Indian law and tax, not legal or tax advice. ESOP rules and taxation are technical and depend on the specific facts of your company and situation, and the law changes. For advice on setting up or accepting an ESOP, speak to a qualified lawyer and tax adviser.
If you are setting up an ESOP for your company or reviewing an ESOP offer, our team can help you get the scheme, the resolutions, and the documentation right. We handle contract drafting, shareholders’ agreement drafting, and company registration in India, and you can speak to our contract lawyers in India.
