An Employee Stock Option Plan (ESOP) gives employees the right, but not the obligation, to buy a fixed number of company shares at a pre-agreed price after a set period. For an Indian private limited company it is governed by Section 62(1)(b) of the Companies Act, 2013 read with Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014. Listed companies additionally follow the SEBI (Share Based Employee Benefits and Sweat Equity) Regulations, 2021. An ESOP lets a cash-strapped startup reward talent with ownership instead of a heavy salary outgo, while giving employees a stake in the upside they help create.
Key terms you should know
- Grant: the formal offer of options to an eligible employee.
- Vesting: the point at which an employee earns the right to exercise options, usually spread over several years.
- Exercise: paying the exercise price to convert vested options into actual shares.
- Exercise price: the pre-fixed price per share; unlisted companies may set this freely, backed by a registered valuer's report.
How to roll out an ESOP
- The Board approves the ESOP scheme and the size of the option pool.
- Shareholders approve it by Special Resolution. A separate resolution is required to grant options to employees of a subsidiary or holding company, or where any one employee is granted options for 1% or more of the issued capital.
- File Form MGT-14 with the ROC within 30 days of passing the resolution.
- Issue grant letters and maintain the statutory register in Form SH-6.
- After vesting, the employee exercises the options and pays the exercise price.
- Allot the shares and file Form PAS-3 within 30 days of allotment.
Conditions under the Companies Act
- A minimum one-year gap between grant and vesting is mandatory.
- Options cannot ordinarily be offered to promoters or to directors holding more than 10% of equity, but DPIIT-recognised startups are exempt from this bar for 10 years from incorporation.
- Options are non-transferable and typically lapse on cessation of employment as per the scheme terms.
How ESOPs are taxed
There are two taxable events. On exercise, the difference between the fair market value (FMV) and the exercise price is taxed as a perquisite (salary income) under Section 17(2), with TDS deducted by the employer. On sale, any gain over the FMV is taxed as capital gains.
| Stage | Head of income | Rate (FY 2026-27) |
|---|---|---|
| Exercise (FMV minus exercise price) | Salary perquisite | Applicable slab rate |
| Sale of unlisted shares held up to 24 months | Short-term capital gains | Slab rate |
| Sale of unlisted shares held over 24 months | Long-term capital gains | 12.5% without indexation |
Startup deferral: Employees of a startup that holds both DPIIT recognition and an 80-IAC (Inter-Ministerial Board) certificate can defer the perquisite TDS to the earliest of 48 months from the end of the relevant assessment year, the sale of the shares, or leaving the company; this window is extended to 60 months for shares allotted on or after 1 April 2026.
Common mistakes to avoid
- Skipping the registered-valuer FMV report, which is the base for both perquisite tax and future capital gains.
- Missing the MGT-14 or PAS-3 deadlines, which attract per-day late-filing penalties.
- Treating the option pool as issued shares; options dilute equity only when they are exercised.