How to Design and Implement an Employee Stock Option Plan (ESOP) Under the Companies Act 2013 in India

Employee Stock Option Plans (ESOPs) have become one of the most important tools for attracting, retaining, and incentivising talent in Indian companies, from early-stage startups to large listed corporations. An ESOP grants employees the right to purchase shares of the company at a predetermined price (the exercise price) after a specified vesting period. The legal framework for ESOPs in India is primarily governed by Section 62(1)(b) of the Companies Act, 2013, and Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014. For listed companies, the SEBI (Share Based Employee Benefits and Sweat Equity) Regulations, 2021 (SEBI SBEB Regulations) impose additional compliance requirements.

This guide walks you through the complete process of designing and implementing an ESOP, covering the legal requirements, the distinction between the trust route and the direct route, SEBI compliance for listed companies, and the tax implications for both the company and the employees. For companies navigating other aspects of corporate compliance, our guide on how to register under the Shops and Establishments Act and our article on how to apply for revocation of GST registration cancellation may also be useful.

Legal Framework for ESOPs

The primary legal provisions governing ESOPs in India are as follows. Section 62(1)(b) of the Companies Act, 2013, empowers a company to issue shares to its employees under a scheme of employees' stock option, subject to a special resolution passed by the shareholders. Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014, prescribes detailed requirements for the ESOP scheme, including the minimum vesting period, the exercise period, disclosure requirements, and the treatment of employees who resign or are terminated.

For listed companies, the SEBI (Share Based Employee Benefits and Sweat Equity) Regulations, 2021, provide an additional layer of compliance. These regulations replaced the earlier SEBI (Share Based Employee Benefits) Regulations, 2014, and consolidated the framework for all share-based employee benefits, including ESOPs, Employee Stock Purchase Schemes (ESPS), Stock Appreciation Rights (SARs), Restricted Stock Units (RSUs), and General Employee Benefit Schemes.

Key Requirements Under the Companies Act, 2013

To implement an ESOP under the Companies Act, 2013, the following requirements must be satisfied.

Special Resolution: The company must pass a special resolution (requiring a 75% majority) at a general meeting of shareholders to approve the ESOP scheme. The explanatory statement annexed to the notice of the general meeting must contain prescribed particulars, including the total number of stock options to be granted, the identified classes of employees eligible, the vesting requirements, the exercise price or the pricing formula, the exercise period, the appraisal process for determining eligible employees, and the maximum number of options to be issued per employee.

Minimum Vesting Period: The minimum vesting period is one year from the date of grant of the options. This means that an employee cannot exercise any options until at least one year has elapsed from the grant date. Companies typically adopt a graded vesting schedule (for example, 25% of the options vesting at the end of each year over a four-year period) to incentivise long-term retention.

Exercise Period and Price: The company's ESOP scheme must specify the exercise period within which employees can exercise their vested options, and the exercise price or the formula for determining it. The exercise price can be at a discount to the market value, at par value, or at a premium, as determined by the company.

Eligibility: ESOPs can be granted to permanent employees working in India or outside India, and to directors of the company (including whole-time directors but excluding independent directors and promoter directors or members of the promoter group). ESOPs can also be granted to employees of subsidiary companies and holding companies, subject to the terms of the scheme and the special resolution.

Direct Route vs. Trust Route

There are two primary routes for implementing an ESOP in India: the direct route and the trust route.

Under the direct route, the company issues fresh shares directly to the employees upon exercise of their vested options. This is the route expressly contemplated by Section 62(1)(b) of the Companies Act, 2013. The advantage of the direct route is simplicity: shares are allotted directly from the company to the employee, and there is no intermediary entity. However, each exercise results in a fresh issuance of shares, which dilutes existing shareholders.

Under the trust route, the company sets up an ESOP Trust (typically a private irrevocable trust) that acquires shares, either by subscribing to fresh shares issued by the company or by purchasing shares from the secondary market. The trust holds the shares and transfers them to employees upon exercise. The trust route is particularly relevant for listed companies, as the SEBI SBEB Regulations, 2021, expressly permit trusts to acquire shares through secondary acquisition from the stock exchange. However, under the Companies Act, the trust route for fresh issuance has some ambiguity, as Section 62(1)(b) read with Rule 12 is primarily designed for direct issuance to employees.

Listed companies frequently use the trust route for secondary acquisition, as it allows them to manage dilution by buying shares from the open market rather than issuing new shares. For related SEBI compliance insights, see our article on how to file an investor complaint with SEBI and our coverage of the SEBI Buy-Back of Securities (Amendment) Regulations 2026.

SEBI SBEB Compliance for Listed Companies

Listed companies implementing ESOPs must comply with the SEBI (Share Based Employee Benefits and Sweat Equity) Regulations, 2021, in addition to the Companies Act requirements. Key SEBI requirements include the following.

Compensation Committee: The company must constitute a Compensation Committee comprising a majority of independent directors, which administers the ESOP scheme. The committee determines individual grants, monitors vesting, and resolves disputes related to the scheme.

Shareholder Approval: In addition to the special resolution under the Companies Act, a separate approval is required if the ESOP scheme involves secondary acquisition through a trust. The company must also obtain shareholder approval for granting options to employees of subsidiary or associate companies.

Disclosure Requirements: Listed companies must make detailed disclosures in the Board's Report and the Annual Report regarding the ESOP scheme, including the number of options granted, vested, exercised, and lapsed during the year, the exercise price, the pricing methodology, and a dilution statement. The company must also file scheme-related disclosures with the stock exchanges.

Annual Certificate: A certificate from the auditors of the company must be obtained confirming that the ESOP scheme has been implemented in accordance with the SEBI SBEB Regulations and the resolution of the shareholders.

Tax Implications of ESOPs

The taxation of ESOPs in India involves two stages of tax incidence for the employee.

First Stage, Perquisite Tax at Exercise: When an employee exercises their stock options and acquires shares, 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 under Section 17(2)(vi) of the Income Tax Act, 1961. This perquisite is added to the employee's salary income and taxed at the applicable slab rate. The employer is required to deduct Tax Deducted at Source (TDS) under Section 192 on this perquisite.

Second Stage, Capital Gains at Sale: When the employee subsequently sells the shares, the difference between the sale price and the FMV on the date of exercise (which is the cost of acquisition for capital gains purposes) is taxed as capital gains. For listed shares held for more than 12 months, the gain is taxed as Long-Term Capital Gains (LTCG) at 12.5% (with an annual exemption of INR 1.25 lakh). For unlisted shares held for more than 24 months, the LTCG rate is also 12.5% (without indexation). Short-term capital gains on listed shares are taxed at 20%, while short-term gains on unlisted shares are taxed at the applicable slab rate.

Tax Deferral for Eligible Startups

For employees of eligible startups, Section 192(1C) of the Income Tax Act provides a deferral of the perquisite tax arising at the time of exercise. This deferral is available to employees of startups that hold the Inter-Ministerial Board (IMB) certification under Section 80-IAC. The perquisite tax is deferred until the earliest of: (a) 48 months from the end of the assessment year in which the options were exercised; (b) the date the employee sells the shares; or (c) the date the employee ceases to be an employee of the company.

It is important to note that this deferral is purely a timing benefit; it does not reduce the quantum of tax payable. As of April 2026, only about 3,700 of the 1.97 lakh DPIIT-recognised startups hold the IMB certification required to extend this benefit to their employees. The Union Budget 2026-27 discussions include proposals to extend this deferral to all DPIIT-recognised startups, but this has not been enacted yet.

Cross-Border ESOP Grants for MNCs

Multinational companies with Indian subsidiaries frequently grant ESOPs of the parent company (typically a US, UK, or Singapore entity) to their Indian employees. These cross-border ESOP grants raise additional compliance considerations under FEMA (the employee receives shares of a foreign company, which is treated as an overseas investment), the Income Tax Act (TDS obligations on the perquisite), and the Companies Act (if the Indian subsidiary is issuing guarantees or providing any consideration for the ESOP). Companies handling cross-border ESOP grants should coordinate with FEMA counsel to ensure compliance with the Liberalised Remittance Scheme (LRS) limits and the reporting requirements for overseas investments by resident individuals.

For companies also addressing workplace policies alongside ESOP implementation, see our guide on how to file a sexual harassment complaint under the POSH Act 2013. Companies considering structural changes to accommodate ESOP implementation may also refer to our article on how to convert a private company to a public company under the Companies Act, 2013.

Accounting Treatment

Under Indian Accounting Standard (Ind AS) 102 on Share-based Payment, the company must recognise the cost of the ESOP as an employee benefit expense over the vesting period. The expense is measured at the fair value of the options on the grant date, using an appropriate option pricing model (such as the Black-Scholes model). This expense is recognised in the profit and loss statement, with a corresponding credit to the Employee Stock Options Outstanding account in equity. Companies that are not required to follow Ind AS must follow the Guidance Note on Accounting for Employee Share-based Payments issued by the ICAI.

---

Conclusion

Designing and implementing an ESOP requires careful attention to the legal framework under the Companies Act, 2013, the SEBI SBEB Regulations (for listed companies), and the Income Tax Act. The process involves obtaining shareholder approval through a special resolution, drafting a comprehensive ESOP scheme document, selecting the appropriate implementation route (direct or trust), ensuring proper valuation, and managing the tax compliance for both the company and the employees. When executed well, an ESOP can be a powerful tool for aligning employee interests with shareholder value while retaining critical talent in a competitive market.