How to Set Up an ESOP Scheme in a Private Limited Company

Every founder deck promises ESOPs. Few founders know that an employee stock option scheme in a private company is a creature of two provisions: section 62(1)(b) of the Companies Act, 2013, which routes ESOPs through a special resolution, and rule 12 of the Companies (Share Capital and Debentures) Rules, 2014, which prescribes who can receive options, what shareholders must be told, and how the scheme runs for its whole life. This guide covers the company-law setup only. It does not cover the tax treatment of ESOPs or FEMA, and states no income-tax ESOP rule.

The legal route: further issue to employees by special resolution

When a company with share capital proposes to increase its subscribed capital by issuing further shares, the Act channels the issue three ways: rights to existing holders, employees under an ESOP scheme, or others by preferential offer (s.62(1), Companies Act 2013). The ESOP channel reads: to employees under a scheme of employees' stock option, subject to special resolution passed by the company and subject to prescribed conditions (s.62(1)(b), Companies Act 2013). Two consequences follow. First, an ordinary board resolution never suffices — shareholders must pass a special resolution. Second, rule 12 applies to a company other than a listed company that is not required to follow SEBI's employee stock option scheme guidelines, and it provides that such a company "shall not offer shares to its employees" under an ESOP scheme "unless it complies with the following requirements" (rule 12, Share Capital and Debentures Rules 2014).

Who counts as an employee — and who is excluded

The rule defines its own universe. "Employee" means a permanent employee in or outside India, a director (whole-time or not, but excluding independent directors), and such persons in a subsidiary or holding company in or outside India (rule 12(1) Explanation (a)–(c), Share Capital and Debentures Rules 2014). Two exclusions bite founders: promoters and promoter-group persons cannot receive options, and neither can a director who holds — directly, through relatives, or through bodies corporate — more than ten per cent of outstanding equity (rule 12(1) Explanation (i)–(ii), Share Capital and Debentures Rules 2014). A founder-director with a large stake is outside the scheme by definition.

Startups get a holiday: for a startup company as defined in notification G.S.R. 127(E), dated 19 February 2019, issued by the Department for Promotion of Industry and Internal Trade, the two exclusions do not apply up to ten years from the date of incorporation or registration (proviso to rule 12(1) Explanation, as amended by the Share Capital and Debentures Amendment Rules 2019). The original rule said five years and referred to a 2016 notification; the 2019 amendment substituted ten years and the 2019 notification. Whether a company is a startup under that notification is a fact to confirm against the notification itself. Within the holiday, promoter-employees and large-shareholder directors can be granted options; after it, the exclusions apply again.

The thirteen disclosures shareholders must see

The explanatory statement annexed to the special-resolution notice must carry thirteen items (rule 12(2)(a)–(m), Share Capital and Debentures Rules 2014): the total options to be granted; the classes of employees eligible; the appraisal process for eligibility; vesting requirements and period; the maximum vesting period; the exercise price or its formula; the exercise period and process; any lock-in; the per-employee and aggregate maximum; the valuation method; lapse conditions such as misconduct termination; the window to exercise vested options on resignation or termination; and a statement of compliance with applicable accounting standards. This is the scheme's constitution as far as shareholders are concerned — draft it once, draft it completely, because varying it later needs another special resolution (rule 12(5), Share Capital and Debentures Rules 2014).

Two grants need a separate shareholder resolution on top of the scheme approval: options to subsidiary or holding-company employees, and options to identified employees equalling or exceeding one per cent of issued capital (excluding outstanding warrants and conversions) in any one year (rule 12(4), Share Capital and Debentures Rules 2014). If the plan includes grants to a foreign subsidiary's team or a large grant to a senior-executive hire, calendar the second resolution from the start.

Vesting, exercise, and the option-holder's limits

The floor is one year between grant and vesting (rule 12(6)(a), Share Capital and Debentures Rules 2014), with merger-adjusted carryover where replacement options substitute for a merged company's scheme (proviso to rule 12(6)(a), Share Capital and Debentures Rules 2014). The company may set any lock-in on shares issued on exercise (rule 12(6)(b), Share Capital and Debentures Rules 2014). Until shares are issued on exercise, the employee has no dividend, no vote, and no shareholder benefit from the option (rule 12(6)(c), Share Capital and Debentures Rules 2014). Exercise price is the company's to fix in line with applicable accounting policies (rule 12(3), Share Capital and Debentures Rules 2014).

Money paid at grant has two fates: forfeiture if the employee lets the exercise period lapse unexercised, or refund if vesting conditions fail (rule 12(7), Share Capital and Debentures Rules 2014). The scheme document should state which applies and when, because disputes cluster exactly here.

Options are personal and locked: non-transferable, non-pledgeable, non-encumberable in any form, exercisable only by the grantee (rule 12(8)(a)–(c), Share Capital and Debentures Rules 2014). Three events rewrite the position by operation of the rule. Death in employment vests all granted options in the legal heirs or nominees (rule 12(8)(d), Share Capital and Debentures Rules 2014). Permanent incapacity in employment vests everything granted as of that date in the employee himself (rule 12(8)(e), Share Capital and Debentures Rules 2014). Resignation or termination kills all unvested options on the day of exit, while vested options survive for the scheme-specified exercise window (rule 12(8)(f), Share Capital and Debentures Rules 2014).

Varying the scheme and reporting it

Un-exercised scheme terms may be varied by special resolution, never prejudicially to option holders, with the variation notice disclosing the full change, its rationale, and the beneficiary employees (rule 12(5), Share Capital and Debentures Rules 2014). Every year the board's report must disclose the scheme's vital statistics: granted, vested, exercised, shares arising, lapsed, exercise price, variations, money realised, options in force, and grants to key managerial personnel, to anyone receiving five per cent or more of the year's grants, and to anyone at or above the one-per-cent-of-capital line (rule 12(9), Share Capital and Debentures Rules 2014). And the company must maintain a Register of Employee Stock Options in Form SH-6 — at the registered office or a board-approved place, entries authenticated by the company secretary or a board-authorised person — recording every option granted under section 62(1)(b) (rule 12(10), Share Capital and Debentures Rules 2014). Where the company's equity shares are listed on a recognised stock exchange, the scheme is issued under the regulations made by SEBI instead (rule 12(11), Share Capital and Debentures Rules 2014); SEBI's employee stock option and stock purchase scheme regulations are outside this guide.

Step-by-step: the setup sequence

• Define the pool and the population. Total options, eligible classes, per-employee and aggregate caps, valuation method (rule 12(2), clauses (a), (b), (i) and (j), Share Capital and Debentures Rules 2014); check promoter and ten-per-cent exclusions, or the ten-year startup holiday (rule 12(1) Explanation; startup proviso, Share Capital and Debentures Rules 2014).
• Draft the scheme with all thirteen disclosures — vesting, exercise price and process, lock-in, lapse and exit windows, accounting-standards statement (rule 12(2), Share Capital and Debentures Rules 2014).
• Pass the special resolution under section 62(1)(b) (s.62(1)(b), Companies Act 2013; rule 12(1), Share Capital and Debentures Rules 2014); take separate resolutions for subsidiary/holding-company grants or one-per-cent-plus individual grants (rule 12(4), Share Capital and Debentures Rules 2014).
• Grant with a one-year minimum vesting clock (rule 12(6)(a), Share Capital and Debentures Rules 2014); record every grant in the SH-6 register (rule 12(10), Share Capital and Debentures Rules 2014).
• Report annually in the board's report (rule 12(9), Share Capital and Debentures Rules 2014) and vary terms only by non-prejudicial special resolution (rule 12(5), Share Capital and Debentures Rules 2014).

What to do now

• Next step: confirm the company is unlisted, then pass the special resolution with the rule 12(2) explanatory statement before any option is offered (s.62(1)(b), Companies Act 2013; rule 12(1) and 12(2), Share Capital and Debentures Rules 2014).
• Deadline: rule 12 sets no calendar date for adopting a scheme; the gate is timing, because shares cannot be offered under the scheme until the requirements are met (rule 12, Share Capital and Debentures Rules 2014). Vesting cannot be earlier than one year after grant (rule 12(6)(a)).
• Consequence of skipping it: the company "shall not offer shares to its employees" under an ESOP scheme unless it complies (rule 12, Share Capital and Debentures Rules 2014).

Have a CA review your facts before you act or file.

FAQ

Can we grant ESOPs by board resolution to move fast?
No. ESOP issues require shareholder approval by special resolution (s.62(1)(b), Companies Act 2013; rule 12(1), Share Capital and Debentures Rules 2014). A board-only grant does not meet section 62(1)(b), which requires a special resolution of the company, and rule 12 says the company shall not offer shares under an ESOP scheme unless it complies with its requirements.

Can our founder-CEO with thirty per cent equity get options?
Not unless the company is within the startup ten-year holiday. Directors holding over ten per cent directly or indirectly are excluded from "Employee" (rule 12(1) Explanation (ii), Share Capital and Debentures Rules 2014); the exclusion lifts only for a startup under notification G.S.R. 127(E) of 2019, for up to ten years from incorporation or registration (proviso to rule 12(1) Explanation, as amended in 2019).

Can an employee sell or pledge unvested options?
No. Options are non-transferable and cannot be pledged, hypothecated, mortgaged or otherwise encumbered or alienated, and only the grantee may exercise them (rule 12(8)(a)–(c), Share Capital and Debentures Rules 2014).

What happens to options when an employee resigns?
Unvested options expire on the exit date; vested options may be exercised within the scheme-specified window (rule 12(8)(f), Share Capital and Debentures Rules 2014). State that window in the scheme — rule 12(2)(l) requires it (rule 12(2)(l), Share Capital and Debentures Rules 2014).

Do option holders vote at meetings before exercising?
No. No dividend, no vote, no shareholder benefits until shares are issued on exercise (rule 12(6)(c), Share Capital and Debentures Rules 2014).

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See Also

• Buying back your own shares (s.68): the 25% ceiling, the board-vs-members route, and the solvency paper trail
• Will CSR ever apply to your startup? Section 135 triggers, the 2% spend and unspent money
• Sweat equity shares: issuing shares for know-how instead of cash (s.54)