ESOP Buyback and Exit Planning under the Companies Act

How startups can manage liquidity, employee exits, and investor alignment during ESOP buybacks

Introduction

Employee Stock Option Plans (ESOPs) are often celebrated for their ability to attract and retain top talent, but the real test of their value comes when employees seek liquidity. An ESOP has meaning only when it translates into tangible ownership value — either through an IPO, secondary sale, or company buyback.

For Indian startups, buybacks and exits must be handled carefully within the Companies Act, 2013 framework and the Companies (Share Capital and Debentures) Rules, 2014. Done right, an ESOP buyback can boost morale, reward long-term employees, and reinforce the company’s reputation for good governance. Done wrong, it can create legal exposure and investor mistrust.

This article explains how to plan and execute an ESOP buyback legally and strategically — from board approval to cash payout — with insights from real startup scenarios.

Understanding ESOP Buybacks in India

An ESOP buyback occurs when a company repurchases its own shares from employees who have exercised their stock options. This creates a liquidity event for employees, allowing them to monetise their ownership without a public listing.

Buybacks are particularly common in private companies where shares are not listed on any exchange. Under Section 68of the Companies Act, 2013, a company can buy back its shares out of:

1. Free reserves,
2. Securities premium account, or
3. Proceeds of an earlier issue (other than fresh issue of the same kind of shares).

The law restricts buybacks to a maximum of 25% of paid-up equity capital and free reserves in a financial year, ensuring financial prudence.

For startups, ESOP buybacks are typically approved post-funding — for example, when a Series B company sets aside ₹5–10 crore to provide partial liquidity to early employees. These buybacks can be selective and limited, but they must follow precise procedures and disclosures.

Legal Framework and Approvals

A buyback under Section 68 requires three distinct approvals: Board approval, shareholder approval, and ROC filing.

For small buybacks — up to 10% of paid-up equity and free reserves — only a Board resolution is needed. For higher amounts, a special resolution by shareholders is mandatory. The notice of the meeting must disclose key buyback details, including the total amount, number of shares, method of purchase, price, and rationale.

After approval, the company must file Form SH-8 (Letter of Offer) with the Registrar of Companies, ensuring the buyback offer is open for at least 15 days and not more than 30 days. Post completion, Form SH-9 (Declaration of Solvency) and Form SH-11 (Return of Buyback) must be filed with supporting documents.

Each ESOP buyback must also comply with Rule 17 of the Share Capital and Debentures Rules, which governs timelines, extinguishment of shares, and reporting obligations.

Structuring ESOP Buybacks for Startups

The structure of a buyback depends on the company’s stage, cap table, and investor preferences. Early-stage companies may execute small, internal buybacks through free reserves, while later-stage ventures may undertake structured liquidity events as part of larger funding rounds.

In practice, Indian startups usually adopt one of the following three approaches:

1. Direct Buyback by the Company:
The company repurchases shares from employees at a pre-approved price. The consideration is paid directly, and the shares are extinguished post-completion. This approach requires compliance with Section 68 and Rule 17.

2. Secondary Sale to Investors:
Instead of the company buying back shares, existing investors or new incoming investors purchase ESOP shares from employees. This method does not require buyback compliance but must adhere to FEMA pricing guidelines if the investors are foreign.

3. ESOP Trust Buyback (for advanced setups):
Large or mature companies sometimes route ESOP buybacks through an ESOP Trust, which purchases and holds shares on behalf of employees. This model, though less common for early-stage startups, provides flexibility for repeated liquidity rounds.

Expert Insight:
During one Series C transaction we advised on, the company executed a dual-structured ESOP liquidity round — part direct buyback and part secondary investor sale. The legal design ensured compliance under both the Companies Act and FEMA, while avoiding double taxation for employees.

Valuation, Pricing, and Tax Implications

Pricing is central to every ESOP buyback. The company must ensure that the buyback price is fair, transparent, and supported by valuation reports from a Registered Valuer.

Typically, startups price buybacks at a discount to their latest funding round valuation. For example, if the company’s Series B valuation is ₹400 per share, the ESOP buyback may be priced at ₹250–₹300 per share, representing a fair liquidity value while preserving investor alignment.

From a tax perspective, the difference between the buyback price and the exercise price constitutes capital gains for the employee. Since the 2019 amendment, the buyback tax of 20% (plus surcharge and cess) is paid by the company under Section 115QA of the Income Tax Act, 1961, making the gains exempt in the hands of employees.

This is a critical advantage — employees receive the full buyback amount without additional tax deduction, while the company bears the tax liability.

Disclosure and Reporting Requirements

Transparency is a cornerstone of ESOP buyback compliance. Companies must maintain meticulous records of:

• The number of shares bought back,
• The consideration paid,
• The extinguishment of shares within seven days of completion.

They must also attach the auditor’s certificate confirming compliance with Section 68 and Rule 17 to the Form SH-11filing.

Additionally, the company must disclose buyback details in its Board’s Report and financial statements, including the reasons, quantum, and effect on capital structure.

Failure to file these documents can attract penalties under Section 450 of the Act and damage the company’s compliance reputation.

Aligning Investor and Employee Expectations

The most successful ESOP buybacks are those that balance employee liquidity with investor strategy.

Investors typically support buybacks once the company reaches a certain growth threshold — for instance, post-Series B — as it signals strong fundamentals and creates goodwill among employees. However, excessive buybacks can dilute growth capital and distort valuation optics.

Founders should plan buybacks after discussions with investors, ideally incorporating them into Shareholders’ Agreements (SHA) or ESOP policies. The agreement should define buyback triggers, eligible participants, valuation methodology, and tax responsibilities.

By establishing these principles early, startups avoid confusion during high-pressure liquidity rounds.

Planning ESOP Exits: Beyond Buybacks

While buybacks are the most common liquidity route, they’re not the only one. Startups should view ESOP exit planningas a long-term strategy that includes:

• IPO exits, where employees sell shares on the market post-listing.
• Secondary sales, where new investors purchase shares from employees.
• Strategic acquisitions, where employees tender shares as part of the deal consideration.

Each of these routes has distinct tax and compliance consequences. For example, a secondary sale to a foreign investor invokes FEMA valuation rules, while an IPO sale triggers capital gains taxation on the difference between sale price and FMV at exercise.

In practice, many successful Indian startups — such as Zerodha, Swiggy, and Razorpay — have executed multiple ESOP liquidity events, reinforcing the idea that employee ownership can coexist with investor profitability.

For More Clarity, See Our Related Articles

• ESOP Compliance and Reporting in India — Understand the full legal process of ESOP approvals, filings, and disclosures under the Companies Act.
• How to Design an ESOP Scheme that Works for Startups — Learn how to structure eligibility, vesting, pricing, and performance linkage.
• Taxation of ESOPs for Startups in India — Explore how ESOPs are taxed for employees and companies, and how DPIIT benefits apply.

Together, these guides complete the ESOP Lifecycle Series — from design to compliance to exit.

Conclusion

An ESOP buyback is more than a liquidity event; it’s a cultural milestone. It converts promises into value and builds a bridge between effort and reward. But every buyback must be rooted in legality — backed by valuation, approvals, and filings that demonstrate corporate discipline.

For founders, ESOP buybacks are also a strategic narrative — proof that the company values its people and honours its commitments. When handled transparently, they not only retain talent but also attract better investors, strengthen governance, and create a self-sustaining ownership culture.

About the Author

Prashant Kumar is a Company Secretary, Published Author, and Partner at Pratham Legal, a full-service Indian law firm advising on corporate, regulatory, and transactional matters.

He is a subject matter expert on ESOP structuring, compliance, and taxation, having advised numerous high-growth startups and investor-backed companies on ESOP design, valuation, and exit planning. Over the years, he has led several high-value ESOP transactions and advised on complex taxation issues under the Income Tax Act, 1961 and Companies Act, 2013.

Prashant helps founders and boards translate employee ownership into compliant, tax-efficient, and governance-aligned frameworks.
He can be reached for discussions on ESOP strategy, buybacks, and taxation advisory at:
📞 +91-9821008011
📧 prashant@prathamlegal.com