INTRODUCTION
For practitioners advising Private Limited Companies on talent retention strategy, the Employee Stock Option Plan (ESOP) remains one of the more frequently requested - and, in this author's experience, one of the more frequently mis-scoped - engagements. The request typically arrives framed as a single deliverable: "draft an ESOP scheme." In practice, a properly executed ESOP engagement spans four distinct compliance tracks that are often handled by different functions within a client organisation, or by different advisors entirely: the company law procedure under the Companies Act, 2013; the capital structuring decision of how the option pool interacts with the company's capitalisation table; the financial reporting treatment under Ind AS 102 or the corresponding ICAI Guidance Note; and the income tax treatment in the hands of the employee, including the employer's withholding obligation.
This article sets out each of these tracks as a practitioner's checklist, with the statutory references a CA should have at hand when reviewing or drafting an ESOP scheme for an unlisted Private Limited Company, and flags the points at which these tracks intersect - which is where, in practice, schemes most often require revisiting.
TRACK 1: COMPANY LAW - THE RULE 12 CHECKLIST
The enabling provision is Section 62(1)(b) of the Companies Act, 2013, which permits a company to offer shares to employees under a scheme of employees' stock option, subject to a special resolution and such conditions as may be prescribed. The prescribed conditions are set out in Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014, which remains the operative rule for unlisted companies; listed companies additionally attract the SEBI (Share Based Employee Benefits and Sweat Equity) Regulations, 2021, which are outside the scope of this article.
A practitioner reviewing a proposed ESOP scheme, or drafting one, should work through the following points:
| Checklist Item | Statutory Reference | Practitioner Note |
|---|---|---|
| (a) Eligibility | Rule 12(1) | "Employee" includes permanent employees in or outside India, directors (whole-time or otherwise), and employees/directors of holding, subsidiary, or associate companies. Excluded: promoters/promoter group, and any director holding more than 10% of outstanding equity (directly or through a body corporate). This second exclusion warrants attention in founder-led companies where a founder-director's shareholding, even post-dilution across funding rounds, may remain above 10% - such a director cannot be brought within the scheme, a point easily missed if the cap table is not reviewed alongside the scheme document. |
| (b) Separate special resolutions | Rule 12(1)(a) & (b) | Required where options are granted to employees of a holding/subsidiary/associate company, and where the grant to identified employees in any one year equals or exceeds 1% of issued capital at the time of grant. If the scheme is silent on these scenarios but the hiring plan makes either likely, flag this at the drafting stage - not when a qualifying grant is proposed. |
| (c) Explanatory statement disclosures | Rule 12(3) | Must disclose: total options to be granted; classes of eligible employees; appraisal process for eligibility; vesting requirements and period; maximum vesting period; exercise price or formula; exercise period and process; valuation methodology; conditions for lapse on termination. Substantive drafting here (rather than "at the Board's discretion") reduces queries from shareholders and auditors later. |
| (d) Minimum vesting period | Rule 12(6) | Minimum one year between grant and vesting - mandatory. The proviso permits Board relaxation only for: (i) options granted to employees of a subsidiary/holding company, or (ii) death or permanent incapacity of an employee. Absent these specific circumstances, a scheme providing for vesting earlier than 12 months from grant is non-compliant with Rule 12(6). |
| (e) Procedural filings | Section 117, Section 39(4), Rule 12(9) | Form MGT-14 within 30 days of the special resolution (Section 117). Form PAS-3 on exercise and allotment (Section 39(4)). Form SH-6 - Register of Employee Stock Options under Rule 12(9) - is, in this author's experience, the most frequently overlooked ESOP filing, likely because its maintenance is ongoing rather than a one-time event-triggered filing. A compliance review of any company with an existing ESOP scheme should specifically verify Form SH-6 is maintained and current. |
TRACK 2: THE OPTION POOL AND THE CAPITALISATION TABLE
Neither the Companies Act, 2013 nor Rule 12 prescribes a minimum or maximum size for an ESOP pool - the "pool" itself being a capital structuring construct rather than a term defined in the statute. It represents the quantum of the company's fully diluted share capital, expressed as a percentage, that has been approved by special resolution as available for option grants over time. The approval and creation of the pool does not, by itself, result in the issuance of any shares or any dilution to existing shareholders; dilution arises progressively, and only as options are exercised and shares allotted pursuant to such exercise.
While the statute is silent on pool size, practitioners advising venture-backed and growth-stage Private Limited Companies will be familiar with the convention - observed widely though not universally - of pools in the range of approximately ten to fifteen per cent of fully diluted share capital. This figure should be treated as a market reference point for discussion with the client, not as a default to be applied without regard to the client's specific hiring plan, the seniority of roles the pool is intended to cover, and the client's fundraising timeline.
The point at which this track most commonly intersects with a client's broader commercial position - and where a practitioner's input is of particular value - is the timing of pool creation or expansion relative to an investment round .
| Pre-Money Pool Creation | Post-Money Pool Creation |
|---|---|
| Pool is created/expanded before the investor's shares are issued. | Pool is created/expanded after the investor's shares are issued. |
| Resulting dilution is borne entirely by existing shareholders, in proportion to their pre-transaction holdings, before the investor's post-transaction ownership percentage is determined. | Dilution is shared between existing shareholders and the incoming investor, in proportion to their respective post-transaction holdings. |
| It is standard practice for investors to require, as a term sheet condition, that any pool expansion necessary for the company's near-term hiring plan be effected on a pre-money basis - meaning the cost of the expanded pool falls entirely on existing shareholders (in practice, principally the founders), not the investor. A practitioner advising on a term sheet should specifically model the effect of any proposed pool expansion on a pre-money basis, as the resulting founder dilution is frequently greater than the headline investment percentage alone would suggest - not due to misrepresentation, but because pool mechanics are a separate dilutive event easy to overlook at a high-level review. | |
TRACK 3: ACCOUNTING TREATMENT - IND AS 102 AND THE ICAI GUIDANCE NOTE
Companies to which the Indian Accounting Standards apply account for ESOPs under Ind AS 102 (Share-Based Payment) . Companies following Indian GAAP apply the Guidance Note on Accounting for Employee Share-Based Payments issued by the Institute of Chartered Accountants of India, the core principles of which are aligned with Ind AS 102.
The principle that requires the most explanation to client management - and is, in this author's experience, the single most common point of friction when an ESOP scheme reaches the audit stage for the first time - is that an equity-settled share-based payment transaction gives rise to a recognised expense in the statement of profit and loss, measured by reference to the fair value of the options at the grant date, irrespective of the absence of any cash outflow by the company. The corresponding credit is recognised in equity, typically within a share-based payment reserve.
| Step | What Happens |
|---|---|
| 1. Fair value at grant date | Determined using an option pricing model - Black-Scholes-Merton and binomial lattice models being most commonly applied - taking into account, at minimum: the exercise price, current price of the underlying share, expected volatility, expected life of the option, expected dividends, and the risk-free rate for the option's expected life. |
| 2. Expense recognition over vesting period | The total fair value of options expected to vest is recognised as an expense over the vesting period - not as a single charge at grant or exercise. |
| 3. Graded vesting = separate tranches | Where vesting is graded (e.g., 25% per year over 4 years), each tranche is treated as a separate grant for determining its own vesting period and expense recognition. This results in an accelerated expense recognition pattern relative to straight-line allocation - the P&L impact in early years is disproportionately front-loaded relative to what a straight-line intuition might suggest. Worth explaining to client management at the outset. |
Audit note: For a practitioner conducting the statutory audit of a company that introduced an ESOP scheme during the year under audit, the fair valuation working should be obtained and reviewed as part of the audit, with particular attention to whether the valuation was performed contemporaneously with the grant date or retrospectively at year-end - the latter raising questions as to whether the inputs used (volatility, expected life) genuinely reflect grant-date assumptions rather than being reverse-engineered from a desired expense outcome.
TRACK 4: TAXATION IN THE HANDS OF THE EMPLOYEE - THE TWO-STAGE EVENT
The taxation of ESOPs arises at two points in the option lifecycle, and a practitioner advising either the company (as the person responsible for withholding) or an individual employee should be clear on both.
| Stage | Tax Event? | Treatment |
|---|---|---|
| Grant | No | Employee holds a contractual right contingent on satisfaction of vesting conditions - not an asset that has been transferred or income that has accrued. No withholding obligation arises. |
| Vesting | No | Same as above - vesting confirms the right to exercise but does not itself constitute income. |
| Exercise | Yes - Perquisite | Under Section 17(2)(vi), Income Tax Act, 1961: the amount by which the fair market value (FMV) of the shares on the date of exercise exceeds the amount paid by the employee is taxed as a perquisite forming part of salary. For unlisted companies, FMV is determined per the method prescribed under the Income Tax Rules - typically a merchant banker valuation. The employer's withholding obligation under Section 192 arises at this point, computed at rates applicable to the employee for the relevant FY. Practical note: this is a withholding obligation on a notional gain in illiquid shares, before any sale has occurred - a real cash-flow issue where share value is significant relative to cash salary. |
| Sale | Yes - Capital Gains | Difference between sale consideration and FMV at exercise date (which becomes the cost of acquisition) is chargeable as capital gains. Short-term/long-term classification per holding period from exercise date to sale date, under general provisions governing capital gains on transfer of equity shares. |
THE SECTION 192(1C) DEFERRAL - APPLICABILITY REQUIRES VERIFICATION, NOT ASSUMPTION
The Finance Act, 2020 inserted sub-section (1C) into Section 192 of the Income Tax Act, 1961, effective from Assessment Year 2021-22 , specifically to address the cash-flow difficulty described above for employees of eligible start-ups.
Under Section 192(1C), a person being an "eligible start-up" as referred to in Section 80-IAC, in respect of perquisite income under Section 17(2)(vi), is permitted to deduct or pay tax on such income within fourteen days of the earliest of :
| 1 | Expiry of forty-eight months from the end of the relevant assessment year |
| 2 | The date of sale of the specified security or sweat equity share by the assessee |
| 3 | The date the assessee ceases to be an employee of the eligible start-up |
Practitioner Caution: The point that practitioners should specifically verify - and which, in this author's experience, is the most common source of error in advising on this provision - is that eligibility for Section 192(1C) is tied to the company's status as an "eligible start-up" under Section 80-IAC , which is a narrower and separate certification from general DPIIT recognition under the Startup India initiative.
A company may hold DPIIT recognition (and consequently enjoy benefits such as the patent fee rebate and angel tax exemption under Section 56(2)(viib)) without having obtained the Section 80-IAC certification from the Inter-Ministerial Board - in which case its employees' ESOP perquisites remain taxable under Section 17(2)(vi) in the ordinary course, with the employer's withholding obligation arising at exercise without the benefit of deferral under Section 192(1C).
Given that the conditions and incorporation window prescribed under Section 80-IAC have been subject to periodic legislative extension, a practitioner should confirm the company's current Section 80-IAC status - and the provisions in force for the relevant assessment year - before advising that the Section 192(1C) deferral applies, rather than inferring this from DPIIT recognition alone. This author has discussed the distinction between DPIIT recognition and Section 80-IAC certification at greater length in an earlier article on this platform.
It bears emphasis that Section 192(1C) defers only the timing of withholding and payment of tax - it does not alter the quantum or character of the perquisite, which remains computed by reference to the FMV as on the date of exercise and remains chargeable as salary income for the relevant previous year. The deferral is a cash-flow concession, not an exemption.
A NOTE ON ESOPs VERSUS SWEAT EQUITY - TWO DISTINCT INSTRUMENTS
A question that arises with some regularity is whether options under an ESOP scheme can be extended to consultants, advisors, or other individuals engaged otherwise than as employees or directors. The framework under Rule 12 is, by its terms, confined to employees and directors (including, subject to the conditions discussed above, those of holding, subsidiary, and associate companies) - it does not extend to non-employees.
Where a company wishes to provide equity-linked compensation to a consultant or advisor, the appropriate instrument is typically sweat equity shares under Section 54 of the Companies Act, 2013 . Section 54 carries its own conditions, including that the company must ordinarily have completed at least one year from the date of commencement of business at the time of issue (subject to the exception available to DPIIT-recognised start-ups), and a cap on the value of sweat equity that may be issued in a financial year.
The legal procedure, accounting treatment, and tax characterisation of sweat equity shares differ from those applicable to ESOPs in material respects, and a practitioner should ensure the choice between the two instruments is driven by the nature of the relationship between the company and the individual - employee versus non-employee - rather than treated as a matter of drafting convenience.
CONCLUSION
The four tracks set out above - the Rule 12 procedural checklist, the option pool's interaction with the capitalisation table, the Ind AS 102 expense recognition, and the two-stage taxation including the conditional Section 192(1C) deferral - are each individually well documented in the literature on this subject. What this article has sought to emphasise is the points at which they intersect , because it is at these intersections that ESOP schemes most often require revisiting after the fact: a pool sized without reference to the funding roadmap, a scheme document drafted without input from whoever will compute the Ind AS 102 expense, or a deferral assumed on the basis of DPIIT recognition without verification of Section 80-IAC status.
A practitioner engaged to "draft an ESOP scheme" is, in substance, being asked to coordinate across all four tracks - and scoping the engagement accordingly, at the outset, is what distinguishes a scheme that survives its first audit and its first term sheet from one that requires revisiting at both.
CA Akhil Kumar is a Chartered Accountant and Partner at Akhil Amit And Associates, Pune, with over 10 years of practice in company law, compliance, and corporate advisory for Private Limited Companies and LLPs.
DISCLAIMER: This article is intended for academic and professional discussion purposes only and reflects the provisions in force at the time of writing. The provisions discussed, particularly those relating to Section 80-IAC eligibility and the deferral mechanism under Section 192(1C), have been subject to periodic amendment and should be verified against the law in force for the relevant assessment year. Nothing in this article constitutes legal, accounting, or tax advice. Readers are advised to obtain specific professional advice in the context of their particular facts and circumstances.
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