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”https://www.mondaq.com/”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).
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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