How to Design an ESOP Scheme that Works for Startups in India

Eligibility, Vesting, Pricing Formula, and Performance Linkage Explained

Introduction

For Indian startups competing for talent, Employee Stock Option Plans (ESOPs) are no longer a luxury — they’re strategic currency. Yet, many early-stage founders struggle with structuring ESOPs that balance retention, regulatory compliance, and investor expectations. A poorly designed scheme can lead to dilution shocks, accounting hurdles, or even employee disputes.

This guide breaks down how to design an ESOP scheme that truly works — covering eligibility, vesting, pricing, performance linkage, and legal structuring under Indian law.

What is an ESOP Scheme and Why Do Startups Need It?

An Employee Stock Option Plan (ESOP) allows employees to acquire shares of the company at a future date, typically at a pre-determined price, as a reward for long-term contribution.

In practice, ESOPs align employee interests with business growth — motivating teams to think like owners. For startups, they serve as a cash-efficient incentive when liquidity is tight, especially before major funding rounds or IPOs.

Under Section 62(1)(b) of the Companies Act, 2013 and Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014, ESOPs must be approved by shareholders through a special resolution, and the scheme must specify key terms such as eligibility, vesting period, pricing, and lock-in.

Who Can Be Eligible for ESOPs in India?

ESOPs can be granted to permanent employees and directors of the company or its holding/subsidiary in or outside India — but not to promoters, promoter group members, or independent directors. Eligibility can be extended based on performance, tenure, or criticality of role.

Startups often start with a core team pool — typically covering founding employees, senior leadership, and key contributors in engineering, product, or business development.
However, compliance under Rule 12(1) restricts the scope:

• Eligible: Permanent employees (India or overseas), directors (executive/non-executive), and employees of holding or subsidiary companies.
• Not eligible: Promoters and directors holding more than 10% equity, unless the company is registered as a startup under DPIIT (where a five-year relaxation applies).

Designing eligibility tiers — such as leadership pool, extended pool, and advisor pool — ensures clarity and prevents overcommitment.

How Does the ESOP Vesting Schedule Work?

Vesting defines when employees earn the right to exercise their options. The minimum vesting period under Indian law is one year, though most startups use a four-year vesting schedule with a one-year cliff, ensuring employees earn ownership progressively as they contribute.

Vesting design reflects your startup’s philosophy of commitment and reward. Common approaches include:

• Time-based vesting: Standard 4-year with 1-year cliff (e.g., 25% after year one, then monthly/quarterly thereafter).
• Performance-based vesting: Linked to revenue, KPIs, or funding milestones.
• Hybrid models: Time + performance to balance retention with accountability.

Under Rule 12(6), companies cannot vest ESOPs earlier than 12 months from grant, even if the employee leaves early.

What is the Pricing Formula for ESOPs in India?

ESOPs must be granted at a price determined by the company’s Board, often based on a fair valuation by a registered valuer. Startups typically issue options at face value or discounted fair value, depending on funding stage and investor alignment.

Pricing depends on the company’s lifecycle:

• Early-stage startups: Often use face value pricing (₹10 or ₹1 per share) to simplify administration.
• Growth-stage startups: Use 409A-style valuation from a registered valuer to justify the exercise price.
• Investor-funded companies: Must ensure no preferential advantage compared to investor issue price unless approved by shareholders.

Fair valuation also becomes critical during secondary sales, buybacks, or ESOP trust transactions under Rule 12(3).

How to Link ESOPs with Performance and Retention?

Performance linkage ties ESOP vesting or quantum to measurable outcomes — like revenue targets, funding milestones, or strategic deliverables. It ensures high performers receive meaningful ownership, while maintaining fairness and retention across the organization.

A modern ESOP scheme is not just a time-based incentive — it’s a strategic performance framework.
Startups often use:

• Milestone-based vesting: Linked to business KPIs (e.g., ARR, profitability).
• OKR-based allocation: Adjusting grants annually based on contribution.
• Discretionary top-ups: For retention of key talent post funding rounds.

Documenting performance criteria transparently (in grant letters, not in the main scheme) prevents ambiguity and regulatory scrutiny.

How to Structure an ESOP Pool Strategically?

A startup’s ESOP pool typically ranges from 5% to 15% of its post-money capital, depending on stage and investor expectations. Early clarity on pool size helps manage dilution, investor negotiations, and ensures availability for future hires and retention cycles.

Founders often underestimate ESOP pool impact on cap table dilution.
Investors usually expect the ESOP pool to be created pre-funding, so its dilution doesn’t affect their shareholding.
To structure effectively:

• Allocate 5–10% before Series A.
• Expand to 15% post-Series B or larger rounds.
• Maintain a rolling replenishment mechanism as team size grows.

Cap table simulations and waterfall models can help founders visualize long-term impact — especially during exits or buybacks.

Key Legal Steps to Implement an ESOP Scheme

1. Draft ESOP Policy and Scheme in line with Rule 12.
2. Obtain Board approval and shareholders’ special resolution.
3. File Form MGT-14 and update register of ESOP grants.
4. Obtain valuation certificate from a registered valuer.
5. Issue grant letters specifying vesting, exercise, and lock-in.

Once exercised, the company must allot shares via Form PAS-3 within 30 days and reflect in the cap table.

Common Pitfalls and Best Practices

• Don’t over-allocate early — unvested ESOPs add hidden dilution.
• Keep the scheme language clear; vague performance clauses invite disputes.
• Always disclose ESOP status in due diligence and investor decks.
• Align exercise price and valuation reports to avoid tax mismatches under Section 17(2)(vi) of the Income Tax Act, 1961.

For more clarity, see our related articles:

• ESOP Compliance and Reporting in India
• ESOP Buyback and Exit Planning under the Companies Act
• Taxation of ESOPs for Startups in India

Conclusion

A well-designed ESOP scheme can turn your startup team into long-term partners in growth. Legal compliance is just the foundation — what truly matters is alignment between company goals and employee incentives. With proper structuring, valuation discipline, and transparent communication, ESOPs can evolve from a retention tool to a culture-defining strategy.

About the Author

Prashant Kumar is a Company Secretary, Published Author, and Partner at Eclectic 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@eclecticlegal.com

FAQ: ESOP Design for Startups in India (2025)

Q1. Can DPIIT-recognised startups issue ESOPs to promoters?
Yes, startups registered under DPIIT can grant ESOPs to promoters or directors holding more than 10% equity for up to five years from incorporation.

Q2. What happens to unvested ESOPs if an employee resigns?
Unvested options lapse automatically unless the company provides otherwise in its ESOP policy or grant letter.

Q3. Is valuation mandatory for ESOP grants?
Yes. A valuation from a registered valuer is mandatory at the time of grant and again at the time of exercise for tax and compliance purposes.

Q4. Can ESOPs be cash-settled instead of share-settled?
Yes, companies can design phantom stock plans or SARs (Stock Appreciation Rights) to provide cash-based value instead of shares.