—Guide
ESOP Pools for Indian Startups: Design, Approvals and Taxation
How Indian startups set up ESOP pools: sizing, vesting, the approvals the Companies Act needs, how employees are taxed, and the deferral for eligible startups.
Employee stock options are one of the most powerful tools a startup has to attract and keep people. But an ESOP only works if it's designed well, approved properly, and understood by employees. This guide covers the essentials.
Sizing the Pool
Early-stage startups commonly reserve 5% to 15% of fully diluted shares for ESOPs, based on how many key hires they plan before the next round. Investors often ask for the pool to be created or expanded before their investment, so its dilution falls on existing shareholders.
Key Design Choices
- Vesting: typically four years, often with a one-year cliff. The Companies Act requires at least one year between grant and vesting.
- Exercise price: often face value or a discount to fair value, balancing employee benefit against tax.
- Exercise window: how long employees have to exercise after vesting, and after leaving.
- Good and bad leaver terms: what happens to vested and unvested options on exit.
- Liquidity: how employees might sell — buybacks, secondary sales, or an exit.
Approvals Under the Companies Act
- The board approves the ESOP scheme.
- Shareholders approve it by special resolution, with the disclosures the rules require.
- The resolution is filed with the ROC in MGT-14.
- Options are granted under the scheme, and shares allotted on exercise, with PAS-3 filed.
ESOPs generally can't be granted to promoters or to directors holding more than 10% of shares. DPIIT-recognised startups can grant them to such persons for up to 10 years from incorporation.
How Employees Are Taxed
- At exercise: the difference between fair market value and the exercise price is taxed as salary, and the employer deducts TDS.
- At sale: the gain over the fair market value at exercise is taxed as capital gains.
Deferral for eligible startups
Employees of eligible startups can defer the tax at exercise until the earliest of a set period after the relevant year, sale of the shares, or leaving the company — easing the burden of paying tax before the shares can be sold.
Communicating the ESOP
An ESOP only motivates people if they understand it. Explain vesting, exercise, tax, and liquidity clearly in grant letters and conversations.
Getting Help
Think Filing designs ESOP schemes, handles approvals and filings, and helps with ESOP administration.