What is ESOP: Benefits, Limitations, How Does it Work

An Employee Stock Ownership Plan, commonly known as an ESOP, is a scheme that allows employees to own a stake in the company they work for. Instead of receiving only a fixed salary, employees under an ESOP get the right to buy or receive company shares.

This is an innovative way to reward employees and build long-term commitment towards the company.

This article focuses on how ESOPs work for employees and employers, the rules around it, and what happens when such companies make their stock market debut.

Key Takeaways

• You are taxed at the time of exercise (as salary perquisite) and again at the time of sale (as capital gains).
• You must exercise vested options within the company’s specified timeframe, or they will lapse.
• If you resign before the vesting date, unvested options are usually forfeited immediately.
• Eligible startup employees of DPIIT-recognised startups that also hold an Inter-Ministerial Board (IMB) Certificate of Eligibility under Section 80-IAC may defer their perquisite tax liability for up to 48 months.
• Shares in unlisted companies cannot be sold on exchanges and are subject to internal company transfer restrictions.

Regulatory Governance Over ESOPs

ESOPs in India are mainly covered by both company law and tax law. Under Section 62(1)(b) of the Companies Act, 2013, a company can give employees stock options under an approved ESOP scheme. This allows the company to issue shares to employees without following the usual public or rights issue process.

For listed companies, there are some additional rules. They have to follow the SEBI (Share Based Employee Benefits and Sweat Equity) Regulations, 2021. These rules deal with things like getting shareholder approval, making the required disclosures, and properly managing the ESOP scheme.

So, in simple terms, ESOPs in India are regulated from two main sides:

• Company law: It covers how the ESOP scheme is created, and shares are issued to employees.
• SEBI rules: They apply to listed companies and cover approvals, disclosures, and administration.
• Tax law: This determines how the benefit received by employees through ESOPs is taxed.

How ESOP is Beneficial for Employees?

ESOP allows employees to become shareholders through a trust fund established by their company. The organisation can contribute its own shares, provide cash to purchase stock, or use borrowed funds to acquire shares. Rather than being handed shares immediately, employees typically earn the right to these shares gradually, through a process called vesting. This encourages employees to stay with the company and contribute to its growth.

Companies Where ESOPs are a Common Practice

• Startups that want to attract skilled employees.
• Growth-stage companies aiming to retain key talent.
• Established companies that want to align employee interests with shareholder interests.

How Do ESOPs Work?

An ESOP typically moves through several distinct stages from the time it is granted to the time an employee owns shares:

• Trust: The company creates an ESOP trust and contributes newly issued shares or cash to buy existing shares for the employees.
• Grant: The company offers a specific number of stock options to an employee, often as part of the compensation package.
• Vesting Period: Employees do not buy shares directly. Instead, options convert into an exercisable right gradually, over a vesting schedule.
• Exercise: Once vested, the employee can choose to "exercise" the option. For this, they will need to pay the predetermined exercise price to purchase the shares.
• Sale or Holding: After exercising, the employee owns the shares and can hold them or sell them, based on lock-in conditions or any applicable regulations.

When employees leave the company or retire, they can exercise their option and sell their shares in the open market, depending on whether the company is publicly listed. Private companies also maintain liquidity for employee shares through an ESOP repurchase obligation.

Common ESOP Vesting Schedules in India

Indian companies typically structure vesting while considering these aspects:

• Minimum one-year cliff: The Companies Act mandates a minimum gap of one year between the date of grant and the date of the first vesting.
• Graded/staggered vesting: After the first-year cliff, the remaining options vest in tranches over 3 to 4 years (e.g., 25% each year).
• Cliff vesting: All options vest together on a single date (often the 1-year or 4-year mark) rather than installments.
• Performance-linked vesting: Vesting is tied to individual, team, or company milestones rather than tenure alone.

Why do Companies Offer ESOPs?

Strategic reasons why companies offer this option:

• Talent attraction: ESOPs can help companies, especially startups, compete for skilled employees without offering high cash salaries.
• Aligning interests: By giving employees a stake at the ownership level, the intent is that participants will be motivated to contribute to the success of the company.
• Cash flow management: Offering equity instead of higher cash compensation helps companies conserve cash.
• Employee motivation: Ownership can be a contributing factor in increasing employee engagement.

Startup Tax Deferral Scheme (Section 80-IAC)

DPIIT recognition by itself does not entitle a startup's employees to defer perquisite tax. To offer this deferral, a startup must additionally hold an Inter-Ministerial Board (IMB) Certificate of Eligibility under Section 80-IAC of the Income Tax Act.

As of October 2025, India had close to 1.98 lakh DPIIT-recognised startups, but only 4,147 of them had been issued an 80-IAC eligibility certificate, according to a government reply in the Lok Sabha.

For employees at a certified startup, Section 192(1C) of the Income Tax Act allows the employer to put off deducting TDS on the exercise perquisite until the earliest of three trigger points:

• 48 months counted from the end of the assessment year in which the shares were allotted;
• The date the employee sells the shares;
• The date the employee stops working for the company.

Note: This is a deferral of when the tax is paid, not a waiver.

Tax Implications for ESOPs

In India, the taxation of ESOPs begins when an employee exercises the stock option, and the shares are allotted. Overall, there are two stages when taxes can be triggered:

• Perquisite tax (at exercise): Under Section 17(2)(vi) of the Income Tax Act, 1961, the value of shares allotted either free of cost or at a concessional price is treated as a perquisite, which forms part of the employee's salary income. Accordingly, the employer is required to deduct Tax Deducted at Source (TDS) at the applicable rate on this perquisite value.
• Capital Gains (at sale): When the employee eventually sells the shares, any further gain (or loss) compared to the Fair Market Value (FMV) at exercise may be treated as a capital gain (or loss). For shares of unlisted companies (which covers most startups), a holding period of more than 24 months is needed for the gain to qualify as long-term capital gains, currently taxed at 12.5%. The shorter 12-month threshold for long-term treatment applies only to listed shares, not unlisted ones.

Perquisite Tax Value = (FMV on Exercise Date - Exercise Price) * Number of Options

Note: The FMV on the date of allotment plays no role in this calculation. Only the FMV on the date of exercise is used, together with the exercise price the employee actually paid.

How FMV is Determined:

• Listed companies: FMV is the average of the opening and closing price of the share on the exercise date on a recognised stock exchange. If the share was not traded on that day, the closing price on the nearest preceding trading day is used.
• Unlisted companies: The fair market value of unlisted shares is based on the price they could get if sold in the open market on the valuation date. A merchant banker or accountant can also provide a valuation report for these shares as per rule 11UA of the tax laws.

Benefits of ESOPs for Employees

Proponents of ESOPs argue that such a technique is effective at improving employee motivation, job satisfaction, and loyalty as employees directly benefit from the company's growth and profitability.

• Wealth creation potential: As the company's value increases, employees can benefit financially through appreciation in share value.
• Ownership: Employees may feel more invested in the company's success when they hold equity.
• Long-term financial planning: ESOPs can form a part of an employee's broader wealth-building strategy alongside salary and other investments.

Limitations of ESOPs

While ESOPs can be valuable, there are also some risks involved in such an option:

• Value is not guaranteed: If the company's share price falls below the exercise price, the options may become worthless.
• Illiquidity: In private or unlisted companies, employees may not be able to easily sell shares even after exercising options.
• Concentration risk: Holding a large portion of personal wealth in a single company's stock increases volatility risk.
• Tax implications: Exercising options and selling shares can trigger tax liabilities.
• Linked to company performance: Unlike fixed salary, the value of ESOPs is entirely tied to how the company performs, which can be uncertain.

ESOP vs RSU vs ESPP

	ESOP	RSU	ESPP
What it is	A right/option to buy shares in future	A promise to receive shares outright on vesting	A plan to buy company shares, usually at a discount, during an offer window
Exercise price	Employee pays a predetermined price	Shares are granted for free	Usually a discounted purchase price
Who bears the cost	Employee pays exercise price; company bears dilution	Company bears full cost (no payment by employee)	Employee pays discounted price via payroll deduction
When it's taxed	At exercise (perquisite) and at sale (capital gains)	At vesting (perquisite, based on FMV) and at sale (capital gains)	At purchase (perquisite, on the discount) and at sale (capital gains)