ESOP 201: Beyond Basics to the Questions That Actually Matter

Everyone in the startup ecosystem understands the basics: ESOPs are crucial for attracting talent, aligning incentives, and creating a wider distribution of wealth. But it’s the thorny, nuanced questions that keep surfacing in the founder WhatsApp groups and late-night calls that rarely get the spotlight.

That’s why we’ve created this write-up.

Instead of another theoretical ESOP overview, we’ve compiled the actual questions that we see surface in WhatsApp groups, social media, and private conversations, the ones that determine whether your ESOP program becomes a genuine competitive advantage or just another administrative headache.

To bring you battle-tested insights, we’ve tapped into our network of ESOP experts: Varun Rajda, Founding Partner at Constellation Blu, and our own Mitul Mehta, Head of Finance at Blume. Their combined experience spans legal frameworks, financial optimization, and practical implementation at scale.

We’ve organized their wisdom into four sections:

• Getting ESOP Right for Founders: Critical decisions that shape your equity culture
• Getting ESOP Right for Employees: Navigating offers, negotiations, and exits
• Special Cases: Handling acquisitions, down rounds, founder elevations, and other complex scenarios

A quick note: You’ll notice some intentional repetition across questions. This ensures each section provides enough context to be immediately useful so you can directly jump to read about the issue you face today. 

Let’s dive in.

Chapter 1: Getting ESOP Right for Founders/​Company

When and How to Set up ESOPs

Q1: When should a startup establish its ESOP policy?

A: Day one — ideally at incorporation. This is the single biggest mistake founders make with ESOPs.

As Varun explains, ​“The first and fundamental mistake that most startups make is they don’t execute any kind of an ESOP policy when they are established. That is a fundamental flaw.”

The Informal Commitments Trap

Founders frequently make verbal ESOP promises without documentation, creating unenforceable agreements with ambiguous terms. These casual offers may feel sufficient but lack legal standing when they matter most.

The Required Legal Foundation

A few elements are non-negotiable: a formal ESOP policy document, a compliant board resolution, a shareholder resolution, and an MGT14 filing with the RoC. Varun notes, ​“Until you do these, you technically cannot grant an option, irrespective of what we have communicated. That is all soft and non-binding, and thereafter, in order to regularise the same, one has to plan for some sort of structuring which is unnecessary and highly avoidable.”

The situation below is not uncommon in startups:

• An employee is promised a 4‑year vesting schedule [A vesting schedule determines when an employee gains actual ownership of their stock options. In a typical 4‑year vesting schedule, the employee earns 25% of their options each year, often with a 1‑year ​‘cliff’ where no options vest until the first anniversary of employment, followed by monthly or quarterly vesting thereafter.]. 
• After 3 years, they should have ideally vested 75%
• But without a formal policy, the vesting technically starts only when the policy is created

“Because you have not formed the policy, the day when you form it, technically, the meter starts from that day,” Varun points out.

This creates a mess of inconsistencies when companies try to fix things retroactively:

• Different employees get different vesting schedules
• You’ll see random upfront vesting percentages (50%, 65%, 75%)
• Your cap table becomes needlessly complex

To avoid this mess, ESOP policy should be created alongside company incorporation — it’s as fundamental as your founding documents. This inexpensive, upfront step prevents the eventual scramble to reconcile informal promises. As Varun notes, ​“It’s a very low-cost activity. It’s as good as saying when you’ve incorporated the company, do this alongside it.”

Q2: How should founders determine the strike price for ESOPs?

The strike price (also known as the exercise price) is the pre-determined fixed price at which employees can purchase the company’s shares when they exercise their stock options. 

Strike price creates critical tension: lower strike prices create more potential value for employees but larger accounting expenses for the company.

The P&L Impact

When granting ESOPs, companies must recognize an expense on their P&L based on the ​“spread” — the difference between the fair market value (FMV) and strike price — multiplied by the number of options.

For example:

• A company grants 10,000 options
• The current FMV per share is ₹100
• The strike price is set at ₹25
• The fair value of each option is ₹75 (₹100 — ₹25)
• Total ESOP expense would be ₹750,000 (10,000 × ₹75)

This expense is typically spread over the vesting period. Setting a higher strike price reduces this expense, which can be beneficial for the company, showing better profitability metrics to investors or preparing for an IPO. However, it reduces the value of the ESOPs for employees, affecting motivation and retention.

Practically, the approach to strike price varies based on the company’s stage:

1. Early-stage: Set the strike price at face value (typically 10 rupees) to maximize value for early employees.
2. Growth stage (Series A/B and beyond): Consider a discount to the last funding round price, typically 10 – 25%. This balances rewarding employees while ensuring they have skin in the game.
3. Mature stage: Some companies set the strike price close to the last round price, especially for new hires joining a well-established startup.

Q3: Should private companies set up an ESOP trust?

A: For most private companies, an ESOP trust is an unnecessary overhead. An ESOP trust is a separate legal entity that holds shares on behalf of employees until they exercise their options — essentially an intermediary between the company and employees.

ESOP trusts are more beneficial for public companies or those nearing an IPO. They simplify the process of share transfers when employees exercise options. Private companies should stick with a notional ESOP pool until they’re close to going public.

“All private companies should not go for ESOP Trust, unless they are literally going for public listing or near to that stage. And all public listed companies by default should have an ESOP Trust, at least, that is my worldview.” — Varun

For companies approaching an IPO, the advantages of setting up an ESOP trust include:

1. Simplified administration through centralized management
2. Better control of shareholder count to avoid triggering additional regulatory requirements
3. Streamlined processes during liquidity events like IPOs or acquisitions
4. Enhanced compliance management for securities regulations

Deciding ESOP Pool Distribution

Q1: What are the different approaches to ESOP pool distribution?

A: There are two main schools of thought:

Concentrated Approach

• Selective distribution to key personnel
• Focus on senior and mid-management
• Strategic allocation based on long-term potential

“I’ve seen more of people who want to concentrate it towards select folks who they see being there for the long term.” — Mitul

Broad-based Approach

• Inclusive distribution
• Everyone from entry-level to senior management included
• Focus on collective ownership
• Less common in Indian startups, but there certainly are a few examples

Note: While both approaches can work, companies should recognize that their choice here fundamentally shapes company culture. The concentrated approach may create stronger incentives for key players but can create perceived inequalities, while the broad approach fosters inclusivity but may dilute the impact for top performers. Eventually, it’s the founder’s call. Here are some factors that they usually consider.

Future Potential Over Current Role

“It’s less about designation, but more about responsibility of what you’re looking at this person doing in the future. If there’s a financial controller who you possibly see becoming a CFO down the line, then you may want to consider [ESOPs].” — Mitul

Long-term Commitment 

Look for indicators such as:

• Growth potential within the organization
• Leadership capabilities
• Long-term alignment with company goals

There’s no one-size-fits-all approach, but here are some guidelines:

1. For early-stage startups, a 10% ESOP pool is common when there are two co-founders.
2. For key management personnel (KMP) or critical early hires, consider granting 2 – 3% of the ESOP pool.
3. Use a combination of factors to determine grants:

• Market compensation vs. offered salary
• Criticality of the role
• Stage of the company
• Available ESOP pool size

“It’s a very extensive and a very detailed exercise, honestly, but only the founder is the best judge.” — Varun

Worth noting: There’s an inherent tension between allocating based on compensation gaps (backward-looking) versus future potential (forward-looking). Be clear about which principle takes precedence when they conflict and stick to them. 

Balancing Act

Don’t grant too much too early; however, it should be sufficient enough to attract/​retain, and at the same time substantial but keep it aligned with [individual + organization performance] in the long term. 

Say, if you wish to grant 1000 options, grant — 400 to be vested over 4 years (100 each year, which is time-based, and another 600 to be vested over another 2 years (300 each) starting from the 5^th year, subject to achieving certain milestones. (Closure of Series C Funding, Revenue of $10mn, etc.) 

The above will go hand in hand to achieve the desired purpose and create a win-win situation in the long run.

Q2: Should companies offer ESOPs to junior employees?

A: This is where philosophy meets practicality. The approach varies based on several factors:

1. Compensation Priorities

“With junior folks, what matters to them actually is money in hand. They may not really care about ESOPs.” — Mitul

2. Strategic Considerations

• Focus ESOP pool on mid-management and above
• Provide competitive cash compensation for junior roles
• Maintain a concentrated ESOP pool

3. Practical Reasoning

“You don’t want a very large pool as well. You want it to concentrate, because these are people who can eventually become shareholders.” — Mitul

Chapter 2: The Employee’s Guide to ESOP

Q1: How should employees evaluate an ESOP offer?

A: Look beyond the numbers to evaluate the terms.

When you receive an ESOP offer, evaluate the potential value and practical terms. Focus on these factors:

• Vesting schedule: Monthly vesting after the cliff period is most employee-friendly, as it creates a smoother accrual of value.
• Exercise window: Post-resignation, longer exercise periods (3−5 years) give you more flexibility for tax planning and exit timing.
• Strike price vs. valuation: The gap between your strike price and the company’s valuation determines immediate paper value.
• Company trajectory: Even perfect ESOP terms in a struggling company may be worth less than standard terms in a rocket ship.
• Tax consequences: Understand when and how much tax you’ll owe before exercising.

“The middle ground that most people have reached now is that you typically keep it about three to five years, because once employees have left they would at least have sufficient wealth in the next three, five years to meet their tax obligation.” — Mitul

Q2: What happens to ESOPs in a down round?

A: When a company raises at a lower valuation than previous rounds (a ​“down round”), your ESOP terms typically remain unchanged, but their potential value changes:

• Paper value decreases: The gap between your strike price and the company’s valuation shrinks, reducing the theoretical value of your options.
• Dilution may increase: Down rounds often involve issuing more shares than planned, potentially diluting your ownership percentage.
• New grants may have better terms: New employees might receive options at a lower strike price than you.

In rare cases, companies might renegotiate existing ESOP terms to maintain motivation, but this is uncommon and typically only happens during severe corrections.

Most importantly, though, while a down round is concerning, it doesn’t necessarily predict the company’s eventual exit value. Many successful companies have weathered down rounds on their path to success.

Q3: How are ESOPs typically treated in exit scenarios?

A: Contrary to common belief, if a company has a successful exit, ESOP holders generally receive fair treatment. However, understand the following:

1. Investors often have liquidation preferences that are paid out first.
2. The remaining proceeds are typically distributed pro-rata (or commercially agreed) among founders, other equity shareholders, and employees. 
3. In acquisitions, sometimes acquirers offer new stock options or RSUs to retain key employees.

Here are two possible scenarios to illustrate this. 

1. In case of good exit/M&A (same or higher valuation than the last round)

“If, let’s say, a company has raised INR 100 Cr at a post-money valuation of 500 Cr, and the exit is for INR 1000 Cr, where everybody has gotten back their capital (assuming 1x liquidation preference). Then, if employees hold 10%, on that 1000 Cr, employees will get 100 Cr, undoubtedly,” suggests Varun. 

2. In case of a distress outcome (less than last round valuation).

“If, let’s say, a company has raised INR 100 Cr at a valuation of 500 Cr, and the exit is for INR 120 Cr. Over here, first, the Investors will receive their entire liquidation preference of 100 Cr, and thereafter, the remaining 20 Cr [120 less 100] will be available to be distributed between the remaining shareholders either on a pro-rata basis or as commercially agreed. In that case, even if employees hold 10%, on that 120 Cr, they will receive much less than 12 Cr, due to the above reasons,” said Varun. 

Q4: What are the tax implications of ESOPs for employees in India?

A: In India, ESOPs trigger tax obligations at two distinct points:

1. At exercise: The difference between the fair market value (FMV) and your exercise price is taxed as salary income at your income tax slab rate (potentially up to 30% plus surcharges).
2. At sale: The difference between the sale price and the FMV at exercise is taxed as capital gains (10 – 15% for the long-term, higher for the short-term).

This creates a critical planning challenge: when you exercise options, you owe tax on paper gains without receiving cash to pay that tax.

“99%, at least in India, would be in a situation where they would never ever exercise the vested option but only remain as completely vested option eligible for exercise, since exercise is a trigger point for the income tax to be paid.” — Varun

Q5: How do ESOPs work for employees of Indian subsidiaries of US-based companies?

A: If you’re an employee of an Indian subsidiary of a US company:

1. You may be offered RSUs (Restricted Stock Units) instead of traditional ESOPs.
2. The underlying stock will be of the US parent company.
3. Despite any favorable tax treatment in the US, as an Indian resident, you’ll be taxed according to Indian laws.
4. You may need to comply with additional regulations, such as RBI rules for holding foreign securities.

“Everything gets overshadowed if you are an Indian tax resident employee because irrespective of what the US law requires, the day you exercise, you are taxed as far as India is concerned, and since you are an Indian employee, you are governed by Indian tax laws.” — Varun

Q6: What should employees do if they’re leaving a company before their options are fully vested?

A: Leaving before full vesting requires careful planning:

1. Understand your company’s post-termination exercise window.
2. Consider exercising vested options if you believe in the company’s long-term prospects.
3. Be aware of the tax implications of exercising.
4. If the exercise window is short, negotiate for an extension if possible.
5. For unvested options, check if there’s any provision for accelerated vesting in case of termination without cause.

Q7: What should employees ask about ESOPs when joining a startup?

A: There are three critical documents and aspects to understand:

The ESOP Scheme

“The key terms of the ESOP scheme is one thing that should be asked for. This is the scheme that governs the whole ESOP process and is formally adopted by the board and company. It covers the terms and conditions, exit scenarios, and liquidation scenarios.” — Mitul

The Grant Letter

• Typically provided with the employment agreement
• Covers vesting details and specific terms
• Details your individual ESOP allocation

Strike Price Details

• Understanding how the strike price is determined
• Any applicable discounts
• Future implications

Q8: How does strike price vary across different types of startups?

A: Strike price determination typically varies based on company’s stage and success:

Well-Established Startups

• Might set strike price at or near the last round price
• Often offer a slight discount to that price
• Focus on future value creation

Growing Startups

• May offer more favorable strike prices
• Could provide significant discounts to last round price
• More flexible with terms to attract talent

Early-Stage Startups

• Might offer nominal value strike price
• More generous terms to attract key talent
• Focus on long-term value creation

Chapter 3- Navigating ESOP Special Scenarios

M&A

Q1: What triggers accelerated vesting in ESOPs?

A: The primary trigger for accelerated vesting is an exit event, particularly during M&A scenarios. While startups typically plan for long-term growth, sometimes acquisition opportunities arise earlier than expected, even within 12 – 24 months of operations.

“The single most important reason for accelerated vesting is when there is an exit event. Sometimes, there is an opportunity that comes the founder’s way where what they initially wanted to build versus what’s available now presents a better outcome.” — Varun

Q2: How does accelerated vesting work during an M&A event?

A: In an M&A scenario, unvested ESOPs typically get accelerated to reward employees for the company’s success, regardless of their original vesting schedule. For example, if an employee has completed 1.5 years of a 4‑year vesting period, they might receive the full benefit of their ESOPs immediately upon the M&A event.

“When such an event occurs, it has nothing to do with the employee’s responsibility or obligation. It’s treated like a bonus award.” — Varun

Q3: How do acquiring companies handle existing ESOPs?

A: The treatment of ESOPs by acquiring companies depends on several factors:

1. The overall value of the ESOPs
2. The number of employees continuing with the new company
3. The acquirer’s perspective and plans

Acquirers typically handle existing ESOPs in one of two ways:

• Start fresh with new stock options
• Honour the time served and adjust the remaining vesting period accordingly

“An acquirer might either start from zero or acknowledge your existing tenure. For instance, if you’ve spent one and a half years at the previous company and those options were vested, they might only require you to complete the remaining two and a half years rather than starting a new four-year period.” — Varun

Q4: What happens to ESOPs in an acquihire scenario?

A: Contrary to common belief, ESOPs don’t automatically become worthless in an acquihire situation. The outcome depends on how the deal is structured. Even in acquihire scenarios, companies often try to ensure employees receive comparable or better value through:

1. Higher salary offers
2. New stock options
3. Better terms in the new company

Q5: What determines the treatment of ESOPs in acquisition scenarios?

A: The treatment of ESOPs during acquisitions depends on the acquiring company’s intentions and the nature of the deal:

1. Is it a pure acquisition for assets or technology?
2. Is it meant to be a long-term integration of teams and culture?
3. What’s the strategic value of retaining employees?

“It all depends on how relevant this acquisition is for the acquirer. Is it just a purchase and scrap situation, or is it meant to be a continuation and build-together type of arrangement? These factors determine the final commercial terms.” — Varun.

Team Member’s Elevation to Co-founder

Q1: When employees are elevated to co-founder status, what happens to their ESOPs?

A: The elevation of employees to co-founder status presents an interesting scenario with several considerations:

Immediate Impact

“It’s not quite [a change]. Because to do anything or to change anything at that point, basically it’s perception. It is a perception that now an employee has become a co-founder and holds a piece of the company.” — Mitul

Technical Limitations

Converting ESOPs to shares is not a straightforward process, as the immediate conversion can trigger significant tax implications. As a result, most companies maintain the ESOP structure initially to navigate these complexities.

Timing of Conversion

“What they do is, maybe when rounds are happening, when founders manage to get some liquidity as part of secondaries at a Series C, D sort of thing. At that point, they may simply exercise and say, ​‘okay, fine, here’s the money.’ ” — Mitul

Funding the Conversion

Liquidity events are often leveraged to manage tax obligations and are strategically timed to optimize financial impact, particularly regarding secondary sales opportunities.

Q2: What are the tax implications when converting from ESOPs to direct equity?

A: There are significant tax advantages to consider:

ESOP Tax Structure

“Taxation on ESOPs is a slab rate, so typically, assuming the highest, it goes up to 39%.” — Mitul

Share Ownership Tax Structure

• Long-term capital gains: approximately 12.5%
• Short-term capital gains: approximately 30%

Potential Savings

“You’re essentially dropping from 39% to 12.5% on the delta from there onwards. It’s not from day zero, but at least from there onwards you’re benefited from a tax benefit.” — Mitul

Q3: When is the right time to convert ESOPs to shares for elevated co-founders?

A: The timing depends on several factors:

1. Company Maturity

“It happens in companies that are fairly evolved with sufficient liquidity, otherwise, it’s not happening.” — Mitul

2. Key Considerations

• Company’s liquidity position
• Availability of secondary sale opportunities
• Individual’s ability to manage tax implications
• Overall company growth stage

Final Thoughts: Making ESOPs a Competitive Advantage

ESOPs are more than just compensation — they shape culture, retention, and long-term value creation. Done right, they align incentives and turn employees into true stakeholders. Done wrong, they become an administrative burden and a source of friction.

The best companies treat ESOPs as a strategic tool, evolving them with each stage of growth. Early-stage startups maximize ownership incentives; growth-stage companies balance financial sustainability and market perception. Regular audits, clear communication, and proactive structuring ensure ESOPs remain a strength, not a liability.

If your ESOP program isn’t a competitive advantage yet, now is the time to fix it. A well-designed ESOP strategy pays off — not just for employees but for the long-term success of your company.

Remember, while this guide provides useful, practical insights, ESOP strategies should always be tailored to your specific situation. Use this Q&A as a starting point for deeper discussions with your legal and financial advisors to create an ESOP strategy that aligns with your company’s goals and values.