ESOP Scheme: How to Set One Up in India, Step by Step

Setting up an ESOP scheme in India is a defined legal process, not a document you download and adapt. It runs on section 62(1)(b) of the Companies Act, 2013 read with Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014, and it requires board approval, shareholder approval, a written scheme, a statutory register, and filings with the Registrar of Companies at two separate points.

This guide walks through the sequence step by step, covers pool sizing and vesting design, explains where a valuation is legally required, and flags the decisions founders regret making quickly. It sits under our business valuation services practice because the valuation is the part most schemes get wrong, and it pairs with ESOP under the Companies Act 2013 for the statutory detail.

Before you draft anything: four decisions

The legal process is mechanical. These four choices are not, and changing them after the first grant is expensive and visible.

1. Pool size

Indian venture-backed companies typically set an ESOP pool between 5 and 15 percent of fully diluted equity, with 10 percent as the common anchor at seed and Series A. Size it against the hiring plan for the next 18 to 24 months rather than against a benchmark: count the senior roles you need to fill, work out what each will cost in equity, and add headroom for refresh grants to people already in the business.

The point founders miss is that the pool is almost always created out of existing shareholders’ equity before a round, so it dilutes the founders, not the incoming investor. That makes pool size a negotiating point in the term sheet rather than a purely internal decision. Get it wrong small and you top up at a worse dilution later; get it wrong large and you have given away equity you did not need to.

2. Exercise price

The Companies Act does not prescribe an exercise price. The company sets it in the scheme, and the range in practice runs from face value (often ₹1 or ₹10) to the last round’s fair market value.

This is a tax decision as much as a compensation one. The employee’s perquisite tax at exercise is the gap between fair market value and exercise price, so a nominal exercise price maximises both the perceived upside and the tax bill. A higher exercise price reduces the tax and reduces the apparent gift. Neither is right in the abstract, but the choice should be made knowing the consequence. Our guide to ESOP taxation in India works through the numbers.

3. Vesting design

Rule 12 imposes a minimum vesting period of one year from the date of grant. Beyond that, the design is yours. The Indian market standard mirrors the global one: four years total, with a one-year cliff and then monthly or quarterly vesting.

On the post-termination exercise window: a standard 90-day window forces a departing employee to fund both the exercise price and the perquisite tax within three months, on a share they cannot sell. In practice many simply walk away from vested options, which converts your retention tool into a source of resentment among alumni. Extending the window to two to five years for good leavers costs the company almost nothing and is one of the better founder decisions available here.

4. Who can receive options

Rule 12 restricts eligibility. Permanent employees of the company in or outside India, directors excluding independent directors, and employees or directors of a holding or subsidiary company can all receive options.

The following cannot, as a general rule:

• Promoters and members of the promoter group
• Directors who, alone or through a body corporate, hold more than 10 percent of the outstanding equity
• Independent directors

There is an important carve-out. A DPIIT-recognised start-up may grant options to promoters and to directors holding more than 10 percent, for ten years from the date of incorporation. If that carve-out matters to your cap table, confirm your recognition status before drafting rather than after.

The ESOP scheme setup process, step by step

1. Check the articles of association. If the articles do not authorise the issue of shares under an employee stock option scheme, amend them first. Check authorised share capital at the same time and increase it if the pool would exhaust it.
2. Draft the scheme. The document must cover the total number of options, vesting period and conditions, exercise price and the method of determining it, the exercise period, lapse conditions, treatment of leavers by category, the transfer restrictions, and the administration and grievance process. Options are not transferable, cannot be pledged, and do not carry dividend or voting rights until exercised.
3. Board meeting. The board approves the scheme, approves the explanatory statement for the shareholder notice, constitutes the compensation or ESOP committee, and calls the general meeting.
4. Shareholder approval. A special resolution (75 percent) is required for a public company. A private company may pass an ordinary resolution instead, under the MCA exemption notification G.S.R. 464(E) dated 5 June 2015. A separate resolution is required to grant options to employees of a subsidiary or holding company, and another to vary the terms of an existing scheme.
5. File Form MGT-14 with the Registrar of Companies within 30 days of passing the resolution, with the scheme and explanatory statement attached.
6. Obtain the valuation. A registered valuer or merchant banker report supporting the fair market value. See the section below on why this is not optional in practice.
7. Grant. The board or the ESOP committee approves individual grants, and grant letters go out setting out the number of options, exercise price, vesting schedule and exercise window.
8. Maintain the register in Form SH-6, the statutory Register of Employee Stock Options, recording every grant, the option holder, number of options, vesting schedule, exercise price and current status. This is a compliance requirement, not an internal tracker, and it is examined.
9. On exercise, allot the shares and file Form PAS-3 with the Registrar, then update the register of members and issue share certificates.
10. Disclose in the Board’s Report each year, covering options granted, vested, exercised, lapsed and outstanding, the exercise price, and the variation of terms if any.

Where a valuation is legally required

Founders often treat the valuation as a formality that can follow the paperwork. It cannot, and there are three separate places it binds.

• Accounting. The company must recognise an employee benefit expense for the fair value of options granted, under Ind AS 102 or the ICAI Guidance Note depending on which framework applies to you. Fair value at grant date is computed using an option pricing model, typically Black-Scholes or a binomial model. This charge hits the P&L over the vesting period and surprises founders who assumed ESOPs were free.
• Perquisite tax at exercise. For an unlisted company the fair market value must be determined by a SEBI-registered Category I merchant banker, as at the exercise date or a date not more than 180 days earlier. An internally agreed price is not valid, and the exposure sits with the company as a TDS default, not only with the employee.
• Section 56(2)(x) and pricing. Issuing shares materially below fair value can create tax consequences for the recipient. Where employees are involved this is generally addressed by the perquisite charge, but the valuation is what evidences the position.

The practical answer is to run a valuation at scheme adoption, refresh it annually, and refresh it again after any priced round or material change. Our ESOP valuation guide covers the methods, and 409A valuation vs investor valuation explains why the number used for options is deliberately not the number in your press release.

ESOP scheme timeline and cost

Budget for a company secretary or law firm for the scheme and filings, a registered valuer or merchant banker for the valuation, and ongoing annual costs for the valuation refresh, the accounting charge computation and the register. None of it is expensive relative to the equity being granted, and all of it is cheaper than remediating a scheme during a fundraise.

Mistakes that cost real money

• Granting before the scheme is approved. There is no such thing as a valid grant without an approved scheme. Verbal promises of “0.5 percent” made in an offer letter and formalised eighteen months later are a recurring source of disputes and diligence findings.
• No valuation, or a stale one. A board-resolved share price is not a fair market value for tax. This is the single most common defect we see in unlisted Indian ESOP schemes.
• Promising the start-up tax deferral without the certificate. Deferral requires DPIIT recognition plus an Inter-Ministerial Board certificate, which roughly two percent of recognised start-ups hold. Saying otherwise in a grant letter is a problem you will own.
• Granting to a promoter or a 10-percent-plus director without checking the carve-out. Outside the DPIIT start-up exemption this is not permitted, and unwinding it is unpleasant.
• Neglecting the Form SH-6 register. A spreadsheet is not the statutory register, and its absence surfaces in due diligence, at exactly the moment when a clean cap table matters most.
• No liquidity path. Options with no realistic route to cash are not compensation. Plan a buyback window or a secondary at the next round when you design the scheme, not when employees start asking.

If you are choosing between instruments before you commit to this process, compare ESOPs and sweat equity, RSUs and ESOPs, and phantom stock in India, which avoids the cap table entirely at the cost of a cash liability. The statutory text of the Companies Act, 2013 and the Rules is published by the Ministry of Corporate Affairs, and DPIIT recognition criteria are on the Startup India portal.

The bottom line on setting up an ESOP scheme

The legal sequence is board approval, shareholder resolution, MGT-14, valuation, grant, SH-6 register, and PAS-3 on exercise, and it takes six to ten weeks. The decisions that actually determine whether the scheme works are made before any of that: pool size against the hiring plan, exercise price with the tax consequence understood, a vesting schedule with a humane post-termination window, and a credible path to liquidity. Get those four right and the filings are administration. Get them wrong and no amount of correct paperwork fixes it.

Setting up an ESOP pool, or cleaning up a scheme before a round? KayOne Consulting handles ESOP valuation, pool design and the cap table work as part of fractional CFO support for founder-led companies. See if we’re a fit