Employee stock options, commonly referred to as ESOPs, are an instrumental tool for startups and established firms in India to attract and retain talent. ESOPs are a structured mechanism to allow employees to gain ownership in a company. However, the regulatory framework, legal requirements, and tax implications differ for startups and non-startups in India. Startups have specific advantages under the regulatory framework. The Companies (Share Capital and Debentures) Rules, 2014 allows startups to issue ESOPs to employees, including directors, consultants, and advisors. However, these cannot be granted to promoters or directors holding more than 10% equity unless they meet specific startup criteria defined by the Department for Promotion of Industry and Internal Trade (DPIIT).
The exercise of ESOPs is taxed as a perquisite, with different tax options available for eligible startups, benefiting employees significantly. ESOPs allow employees to purchase company shares at a predetermined price after a vesting period. In India, ESOPs are governed under the Companies Act, 2013, SEBI (Share-Based Employee Benefits) Regulations, and relevant taxation laws.
For established non-startups, regulations are more stringent. Non-listed companies must follow Rule 12 of the Companies (Share Capital and Debentures) Rules, which dictates that employees gain no shareholder rights (e.g., voting or dividends) until shares are issued upon exercising options. The board and shareholders' approval is mandatory, with specific e-forms like MGT-14 and PAS-3 requiring submission to the Registrar of Companies (RoC).
For listed companies, ESOPs are governed by the SEBI (Share Based Employee Benefits and Sweat Equity) Regulations, 2021. SEBI mandates detailed disclosures, trustee governance, and reporting requirements. Furthermore, secondary acquisitions (buying shares for ESOP purposes) are capped at 2% annually and 5% overall of paid-up share capital.
The Indian government, through initiatives like Startup India, has introduced several relaxations for startups in areas such as taxation and compliance. These measures are intended to help startups compete effectively, conserve cash, and incentivize employees through equity-based compensation.
Startups recognized by the DPIIT (Department for Promotion of Industry and Internal Trade) are eligible for special benefits, including the ability to issue ESOPs to promoters and directors owning more than 10% of the company, which is not allowed for non-startups. This flexibility is especially advantageous for startups during their formative years when cash flow constraints prevent them from offering competitive cash salaries.
On the other hand, non-startups must strictly comply with general ESOP rules as outlined in the Companies (Share Capital and Debentures) Rules, 2014, which impose restrictions on who can receive stock options. Non-startups cannot issue ESOPs to independent directors or promoters holding significant equity stakes, limiting their ability to use ESOPs as a tool to incentivize top leadership or founders.
Under the Finance Act, 2020, employees of DPIIT-recognized startups can defer the payment of tax on ESOPs. Instead of being taxed at the time of exercising the options, the tax liability arises later—either when the employee sells the shares or leaves the company, or after five years from the exercise date, whichever is earlier. The compliance burden for issuing ESOPs is reduced compared to non-startups, with fewer disclosures and procedural requirements.
Non-startups operate under stricter regulatory conditions. ESOPs cannot be issued to promoters, directors owning more than 10% equity or independent directors. Shareholder approval through a special resolution is mandatory before ESOPs can be issued. This includes detailed disclosures about vesting schedules, exercise prices, and the dilution impact on shareholders. Listed non-startups must also adhere to the SEBI (Share Based Employee Benefits and Sweat Equity) Regulations, 2021, which emphasize transparency and investor protection. These regulations require periodic disclosures to stock exchanges and compliance with detailed reporting requirements.
Employees of startups recognized by DPIIT enjoy a deferment of tax liability, reducing their financial burden and making ESOPs a more attractive compensation tool. For employees in non-startups, ESOPs are taxed as salary income at the time of exercise. The tax is calculated based on the difference between the fair market value (FMV) of the shares on the exercise date and the price paid by the employee. When employees sell their shares, any additional gain is subject to capital gains tax. If the shares are held for over one year, long-term capital gains tax rates apply.
Tax implications for ESOPs vary based on the employee's timeline of exercising options and selling shares. At the time of Exercise, the difference between the Fair Market Value (FMV) of the shares on the date of exercise and the exercise price paid by the employee is treated as a perquisite and taxed under Income from Salary. At the Time of Sale, when employees sell the shares, capital gains tax is applicable. The tax rate depends on the holding period of the shares. Short-Term Capital Gains (STCG) if sold within one year, gains are taxed at 15% and Long-Term Capital Gains (LTCG) if sold after one year, gains exceeding ₹1 lakh are taxed at 10% without indexation.
Stock options and sweat equity are two powerful tools companies use to reward and retain employees, founders, or other contributors. While both mechanisms involve the transfer of equity, they differ significantly in terms of purpose, regulatory requirements, tax implications, and the benefits provided to the recipients. Stock options, particularly Employee Stock Option Plans (ESOPs), are a method of granting employees the right to purchase a company’s shares at a pre-determined price after meeting certain conditions, such as vesting periods. Stock options grant ownership only after the employee exercises the options and purchases the shares. Employees do not enjoy rights like voting or dividends until they exercise their options and acquire shares. ESOPs can be tailored with specific terms for vesting, exercise periods, and eligibility criteria, offering flexibility for businesses to structure them according to organizational goals. Employees benefit from stock price appreciation, which aligns their interests with the company's growth. Sweat equity shares are issued to individuals in exchange for their contribution of intellectual property, technical know-how, or other non-cash resources. Unlike stock options, sweat equity shares grant immediate ownership, including voting and dividend rights. Recipients become shareholders as soon as the shares are allotted, granting them all associated rights. Sweat equity shares are often issued at a significant discount or for non-cash consideration, such as the assignment of intellectual property rights. There are limits on the percentage of sweat equity a company can issue. Startups have more relaxed caps, allowing issuance of up to 50% of paid-up capital within the first 10 years.
Startups, particularly those recognized under the Startup India Initiative, are allowed to issue sweat equity shares at a discount or for non-cash considerations like intellectual property. This enables startups to conserve cash while rewarding employees and contributors for their expertise. Vesting periods for ESOPs in startups must be a minimum of one year, but they can extend over several years to ensure long-term alignment with the company’s goals. Pricing rules are relatively lenient, allowing startups to issue options at a lower valuation compared to non-startups. For non-startups, the issuance of stock options and sweat equity is more tightly regulated. Pricing must adhere to the Fair Market Value (FMV) as determined by a registered valuer. Vesting schedules and exercise periods must be clearly defined in the ESOP scheme and disclosed to shareholders.
Stock Appreciation Rights (SARs) are cash-settled instruments that provide employees with the benefit of share price appreciation without requiring them to purchase shares. These are increasingly used by companies to avoid dilution and eliminate the tax burden at the exercise stage. SARs are particularly useful for non-startups seeking to reward employees without navigating the complexities of stock option issuance. SARs are subject to taxation under the Income Tax Act, of 1961, and are taxed similarly to Non-Qualified Stock Options (NSOs). The tax implications arise at two stages. At the Exercise stage, for cash-settled SARs, the payout received by the employee is treated as salary income and taxed at the applicable slab rates. For equity-settled SARs, the difference between the FMV of shares on the exercise date and the grant price (if any) is also treated as salary income. At Sale stage, if the SAR payout is converted into shares and these shares are subsequently sold, the gains are subject to capital gains tax. Short-Term Capital Gains (STCG) Taxed at 15% if shares are held for less than 12 months and Long-Term Capital Gains (LTCG) Taxed at 10% on gains exceeding ₹1 lakh if shares are held for more than 12 months.
Incentivizing founders with stock options presents unique challenges and opportunities, especially in companies that do not qualify as startups under the Startup India Policy. While recognized startups can issue stock options to promoters and founders, companies over 10 years old or subsidiaries of larger corporations must explore alternative mechanisms. Additionally, structuring such incentives requires careful negotiation with investors and compliance with regulatory and tax frameworks. A clawback provision is a contractual clause that allows companies to recover stock options or equity benefits granted to employees or founders in cases of misconduct, breach of agreements, or failure to meet performance targets. For founders, clawback provisions provide a safeguard for investors and companies while still aligning the founder's incentives with the company’s long-term growth. In most cases, clawbacks are incorporated into stock option agreements or equity allocation schemes. For management stock options, clawback clauses are particularly critical to mitigate risks associated with significant equity grants. The Companies Act, 2013, under Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014, does not allow non-startups to issue stock options to promoters or directors holding more than 10% of the company’s equity. However, startups defined under the Startup India Policy are exempt from this restriction and can issue ESOPs to promoters and directors.