Why most startup ESOPs look great on paper but disappoint in practice — and what founders can do about it
Indian startup employees have collectively made $1.45 billion through ESOPs since 2020. Zomato’s earliest employees bought shares at Rs. 0.45 per share. Swiggy has run five ESOP buyback programmes worth over Rs. 1,000 crore, benefitting more than 3,200 employees. Flipkart’s early ESOP grants created dozens of millionaires before the Walmart acquisition.
These are the stories that make ESOPs compelling. But for every Zomato early joiner, there are hundreds of startup employees who sat through four years of vesting, exercised their options, paid tax on paper gains, and eventually received little or nothing because the company never reached liquidity.
The promise of ESOPs is real. The delivery, for most startups and their employees, is still work in progress. Here is what founders and employees both need to understand going into 2025-26.
What an ESOP actually is — and what it is not
An Employee Stock Option Plan (ESOP) gives an employee the right to buy shares in the company at a pre-fixed price — the exercise price — at a future date, after a vesting period. The option itself is not a share. It is a right to buy a share.
Think of it this way: if a startup grants you options at Rs. 10 per share today, and the company’s Fair Market Value (FMV) grows to Rs. 500 per share four years later, you can still buy at Rs. 10. That Rs. 490 gap is your gain — in theory.
What it is not: guaranteed income, liquid wealth, or a substitute for a competitive salary unless the company either lists on an exchange, is acquired, or runs a structured buyback programme.
Most startup employees do not fully understand this distinction at the time of joining, and most founders do not explain it clearly enough. That gap in understanding is where ESOP disillusionment begins.
How ESOPs are taxed in India — the part nobody tells you upfront
ESOP taxation in India happens at two points. Both matter, and both cost real money.
Stage 1 — At Exercise (Perquisite Tax)
When you exercise your options — meaning you actually pay the exercise price and receive shares — the Income Tax Act treats the gain as salary income. The taxable amount is:
Perquisite value = (FMV on exercise date — Exercise price) x Number of shares exercised
This perquisite is added to your total salary income for that financial year and taxed at your applicable slab rate — for most startup employees, this is 30% plus surcharge and cess, making the effective rate between 31.2% and 42.7%.
The problem: you owe tax the moment you exercise, even if you have not sold a single share. You are paying real money on a paper gain. The employer deducts TDS under Section 192 (or Section 392 under the new Income-tax Act, 2025, for exercises from 1 April 2026 onwards). If you do not have enough cash, you may need to sell some shares immediately to cover the tax — which is not always possible in an unlisted company.
Stage 2 — At Sale (Capital Gains Tax)
When you eventually sell the shares, capital gains tax applies. Your cost base for this calculation is the FMV on the date you exercised — not the original exercise price — because you already paid tax on the perquisite at exercise.
For unlisted company shares:
- Short-term capital gains (held for less than 24 months after exercise): taxed at your applicable income tax slab rate
- Long-term capital gains (held for more than 24 months): taxed at 12.5% without indexation
For listed company shares:
- Short-term (less than 12 months): 20%
- Long-term (more than 12 months): 12.5% above Rs. 1.25 lakh threshold
The deferral option for eligible startup employees
Employees of DPIIT-recognised startups that also qualify under Section 80-IAC of the Income Tax Act can defer paying perquisite tax at exercise. Tax becomes payable at the earliest of: the date of sale, departure from the company, or 48 months (4 years) after exercise.
This is a significant benefit. Without deferral, you might owe Rs. 84,000 in perquisite tax on paper gains from shares you cannot sell. With deferral, you pay only when you have actual liquidity.
The catch: most DPIIT-registered startups do not qualify under Section 80-IAC, which has stricter eligibility criteria around profitability and CBDT approval. This means the majority of startup employees must pay tax upfront at exercise — creating a genuine cash flow burden that puts many employees off exercising altogether.
The SEBI reform that changes the IPO equation for founders
In June 2025, SEBI approved a significant reform: startup founders holding ESOPs granted at least one year before filing the Draft Red Herring Prospectus (DRHP) can now retain and exercise those options post-IPO. Previously, such ESOPs had to be liquidated before the IPO process began.
This matters for two reasons. First, it aligns India with global norms — in most markets, founders continue to hold equity through the IPO and beyond. Second, it removes a perverse incentive where founders had to cash out ESOP-held shares right before listing, at a point when the company’s value was arguably at its lowest relative to post-IPO potential.
For employees, this reform signals that India’s regulatory framework is progressively moving toward a more founder and employee-friendly equity environment. Cap table planning and IPO structuring now have more flexibility, which ultimately creates more room for employee ESOP pools to survive and be valuable through the listing process.
Why most startup ESOPs fail to deliver — and what founders can do differently
There are structural reasons why ESOPs disappoint, and they are mostly within the founder’s control.
Problem 1: The vesting cliff and the forgotten early employee
Most Indian startups use a standard four-year vesting schedule with a one-year cliff. This is sensible. But it creates a situation where employees who join in the first two years — when the risk was highest — often end up with the same vesting timeline as employees who joined after a Series A or B, when much of the company-building risk was already absorbed.
Founders should consider accelerating vesting for employees who joined in the seed or pre-seed phase, or offering an additional top-up grant at later funding rounds to reflect the extra risk those early joiners took. It is also worth noting that ESOP pools can be partially replenished when founders dilute additional ownership in subsequent rounds — something many founders do not think about at the time of structuring early grants.
Problem 2: The exercise price problem
Exercise prices are typically set at the FMV at the time of the grant. For a seed-stage company, this might be genuinely low — Rs. 5 or Rs. 10 per share. For a Series B or C company granting fresh options, FMV might already be Rs. 200 or Rs. 300 per share. Employees who join late in the growth curve face a much smaller potential gain relative to the risk they still carry (the company might not IPO, might not be acquired, might run buybacks at a discount).
Some startups have experimented with discounted exercise prices for strategic hires or re-grants after a down round. This is permissible within the Companies Act framework, and it makes ESOPs meaningfully more valuable for employees who join at a point when the company is already de-risked in some ways but the equity upside has narrowed.
Problem 3: No liquidity, no value
This is the biggest structural problem. An unlisted startup’s shares cannot be traded on any exchange. The only ways an employee can convert ESOP wealth into cash are an IPO, an acquisition, or a secondary/buyback transaction organised by the company. Most startups do none of these for the first five to eight years, if ever.
Companies like Swiggy (five buyback events since 2018), Razorpay, and Meesho have demonstrated that structured pre-IPO secondary transactions are possible and meaningful — they signal to employees that ESOP wealth is real, not just a number on a grant letter. Founders who proactively organise even one liquidity event before an IPO dramatically improve employee trust in the ESOP programme.
Problem 4: Employees do not understand what they hold
Research consistently shows that a significant proportion of startup employees cannot accurately describe their vesting schedule, exercise price, or the tax consequences of exercising. Most simply wait to be told what to do at a liquidity event, by which point many have already made costly decisions — failing to exercise before leaving a company, not understanding the post-termination exercise window, or unknowingly triggering large perquisite tax bills.
The fix here is straightforward and costs nothing: a short, plain-language document when ESOPs are granted that explains the vesting schedule, the exercise price, the approximate perquisite tax at current FMV, the post-termination window (typically 30 to 90 days in India), and what happens in an IPO, acquisition, or buyback. Accorp Partners’ compliance team prepares exactly these kinds of employee-facing ESOP education documents as part of broader equity compensation advisory — helping both startups and employees understand the full picture before decisions are made. More at accorppartners.com.
What employees should do before exercising their ESOPs
If you are a startup employee sitting on vested options, here is the practical checklist before you exercise:
1. Calculate your total perquisite tax exposure
Take the current FMV (ask your finance team or get it from the latest valuation report), subtract your exercise price, multiply by the number of shares, and apply your income tax slab rate. That is your approximate tax bill at exercise. Make sure you have cash to cover it — or understand that you may need to sell some shares to cover it, if the company permits.
2. Check if your employer qualifies for ESOP tax deferral
Ask your HR or finance team specifically whether the company is DPIIT-recognised under Section 80-IAC (not just DPIIT-registered under the startup definition). If yes, you can defer perquisite tax payment for up to 48 months post-exercise. This is a material difference in cash flow planning.
3. Understand your post-termination window
If you are thinking of leaving, find out exactly how long you have to exercise vested options after your last working day. Most Indian startup ESOP plans specify 30 to 90 days. Missing this window means the options lapse — permanently. This is one of the most avoidable and painful ESOP mistakes employees make.
4. Factor in the 24-month LTCG clock for unlisted shares
If you exercise today and the company runs a buyback or secondary transaction within 24 months, your gain on sale will be taxed as short-term capital gains at your full slab rate, not at the 12.5% LTCG rate. If there is any signal of a near-term liquidity event, the timing of your exercise — relative to when you might sell — matters significantly.
5. Get a professional opinion if your holding is meaningful
If your ESOP grant represents more than six months of your annual salary in notional value, spend Rs. 5,000 to Rs. 10,000 getting a CA’s advice on exercise timing, tax optimisation, and what to do in different liquidity scenarios. The tax decisions around ESOPs compound in ways that make professional advice cost-effective at almost any reasonable grant size.
The realistic picture going into 2025-26
India’s startup ecosystem is maturing. The SEBI founder-ESOP reform in June 2025 is one signal. The fact that Swiggy, Razorpay, Meesho, and others have run successful pre-IPO buybacks is another. Angel tax has been abolished for all investor classes from FY 2025-26, removing one more friction point in startup cap table management.
But the structural problems — high perquisite tax at exercise, limited LTCG deferral eligibility, poor employee education, and thin secondary markets for unlisted shares — remain. ESOPs are genuinely one of the most powerful tools available to startup founders for attracting and retaining talent without paying cash they do not have. They become more powerful the more honestly and clearly they are explained, structured, and executed.
The Rs. 1.45 billion that Indian startup employees have made through ESOPs since 2020 is real. So is the much larger number of employees who received grant letters, sat through vesting cliffs, and eventually received nothing because the company was acquired at a down-round price or simply never reached a liquidity event.
Founders who take ESOP structuring seriously — clear communication, early liquidity events, realistic exercise prices at later stages, and proper tax guidance for their teams — will find that ESOPs do exactly what they are supposed to do: build ownership culture and retain the people who matter most.
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