In India's ever-evolving startup space, balancing founder motivation with investor protection is a high-wire act. Regulatory impediments to traditional ESOPs have prompted creative alternative stock incentive solutions. The ultimate aim? Keeping founders aligned with the venture's success, while preserving value for increasingly cautious investors.
In recent years, India's entrepreneurial landscape has experienced a significant rise in innovative startups and growth-driven enterprises. As these companies scale, founders trade equity for capital, often shrinking their stake to single digits – leading to diminishing motivation as they become minority stakeholders in their own ventures. This scenario has led India Inc. to explore various compensation structures to attract and retain talent, ensuring that founders maintain "skin in the game" and remain vested in the venture's success.
There are various ways to structure stock incentive schemes, the most common being the traditional stock options which provide employees the opportunity to purchase a predetermined number of shares at a later date at a defined price (also known as the "exercise price" or the "strike price") (ESOPs). While many companies adopt ESOPs as an effective method to address talent retention challenges for employees, the implementation for such plans for founders is far from straightforward, especially within India's legal framework.
In this note, we focus on the legal efficacy of ESOPs and other stock incentive schemes – especially from a founder perspective.
Applicable regulatory regime
By way of a quick background, the Indian Companies Act, 2013 (the Act) governs the provisions around grant of ESOPs and sweat equity by unlisted Indian companies. For listed companies, these schemes are also governed by the Securities and Exchange Board of India (SEBI) under the SEBI (Share Based Employee Benefits and Sweat Equity) Regulations, 2021 (ESOP Regulations). However, both the Act and the ESOP Regulations only govern incentive schemes involving share issuances (regardless of the monikers assigned to them) and not cash incentives – the Indian law presently lacks any comprehensive framework for cash-based employee incentives.
Whilst in general parlance, the terms "promoter" and "founder" may be used interchangeably, only the term "promoter" has a legal definition. Whilst there is no bright-line test to identify a "promoter", it is broadly defined to mean the person who has been named as such in a prospectus or is identified by the company in the annual return or who has control1 over the affairs of the company, directly or indirectly whether as a shareholder, director or otherwise. Another litmus test is to see if the board of directors of the entity is accustomed to act in accordance with such person's advice, directions or instructions. In sum, the founder of a company may not necessarily be its "promoter" from a legal perspective if the conditions above are not fulfilled.
The distinction becomes very relevant from an ESOP perspective, as pursuant to the Act and the ESOP Regulations, the grant of ESOPs to individuals classified as "promoter(s)" is prohibited. This restriction is helpfully not applicable to unlisted entities registered as "startups"2 with the Department for Promotion of Industry and Internal Trade, allowing them to issue ESOPs to founders classified as "promoters" subject to certain conditions.
This "promoter" prohibition also does not apply to the issuance of Sweat Equity – as the name suggests, it is an incentive alternative pursuant to which shares are issued at a discount and / or consideration other than cash to individuals for inter alia providing their know-how or value additions. While Sweat Equity is another tool that theoretically offers a stock-based incentive alternative, it lacks the widespread preference that ESOPs enjoy mainly due to statutory limitations in its structure and applicability. Significant hurdles to the popularity of Sweat Equity are the valuation requirements and the mandatory lock-in period. In terms of the requirements under the Act, a valuation needs to be undertaken, both, for the sweat equity shares to be issued as well as the know-how or value additions (for which the sweat equity shares are proposed to be issued). Further, for unlisted companies there is a three-year lock-in from the date of allotment, while in case of listed or proposed to be listed companies, the ESOP Regulations require the sweat equity shares issued to the promoter or promoter group to be locked-in for a period of 18 months (however, if the sweat equity shares issued to the promoter or the promoter group exceed twenty per cent of the total capital of the issuer, the lock-in period on such excess sweat equity shares shall be a reduced period of 6 months). Another limiting factor for sweat equity is the annual issuance cap, restricted to 15 per cent. of the company's paid-up share capital or INR 50 million, whichever is higher, with a total cap of 25 per cent. (with certain exceptions for companies registered as "startups" and those listed on the Innovators Growth Platform). In contrast, ESOPs face no such limits on issuances, valuation requirements and / or lock-in provisions. Consequently, the intricate balance of rewards against regulatory compliance makes Sweat Equity less attractive.
The grey area
As mentioned above, the current regulatory position is not very conducive for founders classified as promoters seeking compensation specifically through ESOPs. As such, there is an increasing resistance from founders to be "identified" as a promoter. The waters become murkier, when an unlisted entity with the founder(s) holding ESOPs (either pursuant to such individuals not being classified as "promoters" or by virtue of the relevant entity enjoying the "startup" exemption status as described above) plans to get listed and is under the SEBI's radar to apply the "promoter" test more robustly.
The law as it stands currently is unclear on the handling of the unexercised ESOPs for an erstwhile non-promoter founder being classified as a "promoter" pursuant to the listing process. The ESOP Regulations do not specifically endorse forfeiting ESOPs upon such a transition, nor do they explicitly protect the rights to these options.
Recognizing this lacuna, SEBI released a consultation paper in March this year to consider and suggest that such founders who were issued incentives prior to being classified as "promoters" be allowed to retain the benefits of their ESOPs (provided they were granted at least one year prior to the date when the company decides to undertake an IPO). The proposal clarifies though that no fresh issuances will be allowed to such promoters post-listing. It will be interesting to see the fine print that emerges pursuant to this proposal once the SEBI consultation process is concluded. Query whether this could incentivize founders to voluntarily come forward as promoters – a categorization that founders try to strongly sidestep (including by actively winding down their stake during the pre-IPO stage – more on this in the section below) given, inter alia, the uncertainty on any ESOPs already held by them and the increased regulatory scrutiny that promoters are generally under.
The investor perspective
Press reports over the past couple of years indicate a rise in the number of dissents by institutional shareholders specifically in respect of ESOP related matters. It seems that whilst principally investors are not opposed to issuance of ESOPs to founders (with such individuals often being both at the helm of the affairs as well as being the face of the business / brand itself – the value proposition in incentivizing the founders is undeniable), there is increasing preference for the stock options to either be exercisable at a value close to the market price, such that there is significant alignment between the investors' and the founders' interests or in case of a discounted exercise price, for the vesting of the options to be tied to specific performance requirements that are well charted. On a related note, investors are also now becoming increasingly wary of incentive schemes where the performance metrics are not well quantified and left open to subjectivity. Proxy advisory firms have also been strongly recommending investors of listed entities to vote against ratifying ESOP schemes which have ambiguous performance metrics and / or which are lopsided in favor of the founders.
A case in point is the PayTM example which drew considerable (media and shareholder) ire for bestowing its "non-promoter" founder with a considerable pool of ESOPs. Interestingly, the founder had reduced his stake to single digits by transferring a significant portion to a family trust just a year before filing to go public– a manoeuvre that enabled him to be not classified as a "large shareholder" / "promoter" and making him eligible for ESOPs. Post this move though, several industry stakeholders questioned whether family trusts should be aggregated when considering shareholding for promoter classification and if reduction of stake under the threshold limit was enough to not be classified as a "promoter", or the other test of exercising "control" should also be tested. These facets still remain dubious as the definitive stance in this case was not clear (the matter was settled recently in January 2025 by payment of penalties, by the directors and officers in charge of the company, to SEBI amounting to circa INR 30 million (USD 350,000)).
From an investor's perspective, while size and potential dilution form the obvious considerations, certain other nuances such as acceleration clauses, treatment of options granted / vested to ex-employees, cash settlement components and their potential impact on the bottom lines may also be important considerations.
Alternate incentive mechanisms
Given the obstacles above, some other alternatives to extend stock incentives to founders include issuance of convertible instruments, where the conversion event is pegged to certain business and / or operations milestones. Another approach could be to make a downward adjustment of the conversion ratio of the convertible securities issued to the other investor shareholders of the company in such a way that on a fully diluted basis, the shareholding of the promoters is adjusted (upwards) to reflect a percentage that they would have been entitled to if they were issued ESOPs – though of course this would entail detailed discussions with the investors. Another option is using restricted share arrangements, wherein a separate class of shares can be directly issued to the founders through a preferential issue – with contractual restrictions placed on transferability and disposal of these shares. A similar arrangement can also be set up with milestone linked partly paid-up shares with calls being made upon achievement of certain pre-identified milestones. Bespoke securities using a combination of elements described above, such as a partly-paid optionally convertible and redeemable instrument, can also be considered.
Whilst some of these unconventional alternatives may seem attractive, they can act as pain points for a company in the gear-up to a listing event (where the capital structure of the company is generally required to be cleaned up) and therefore, such structures would need to be implemented keeping the listing timelines in mind. Of course, any alternative structure would also require discussions with and buy-in from the existing shareholders – given the rise in shareholder activism specifically in relation to ESOP related matters it may be tricky to navigate.
Whilst traditionally, founders have preferred stock settled incentives over cash, there is now a preference for cash-settled Stock Appreciation Rights (SARs) (performance-based incentives that are directly tied to the company's stock price increase, with recipients usually being provided cash equivalent to the increase in the value of the stock from the date of grant) as a form of compensation because they do align employee incentives with company performance without dampening the capital structure and can be continued post-listing as well (subject to necessary approvals) – though of course their feasibility also depends on the cash richness of the entity. Another complementing consideration, as mentioned above, is that Indian law presently lacks any extensive framework for cash-settled incentives making their implementation relatively straightforward with lesser hoops to jump through!
Having said that, it would also be crucial to assess the tax implications in each of these cases summarized above. For instance, while the approach of adjusting conversion ratios is broadly tax neutral (and would not require a fresh valuation exercise), the routes involving restricted share arrangements and / or partly paid shares could potentially have tax consequences for the founders (and would entail valuation exercises being undertaken). Similarly, the taxation of cash payouts (such as cash settled SARs) v. shares issued pursuant to ESOP could differ significantly. Whilst the former (i.e., the entire stock linked cash payout) would be taxable as "salary / perquisite" in the hands of the recipients, sale of shares issued pursuant to ESOP would attract a more beneficial long term capital gains tax regime (of course if the prescribed time limit for holding the shares is complied with).
To sum it up, the diverse interests of stakeholders, including the rising influence of institutional shareholders as well as retail shareholder activism (especially in the listed company context), necessitate careful navigation and implementation of these stock incentives. Successful implementation hinges on balancing the aspirations of founders with the interests of investors, ultimately fostering a harmonious environment conducive to the company's growth and value creation.
Footnotes
1 Under the Act, the term "control" has been defined to include the right to appoint majority of the directors or to directly / indirectly control the management or policy decisions of the entity.
2 Just to mention though that an entity registered as a "startup" will lose this status on completion of ten years from the date of its incorporation or if its turnover for any previous year exceeds INR 1 billion (approx. USD 11.6 million).
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