ESOPs in an Indian D2C Startup: How They Work

An ESOP is a hiring instrument, a retention instrument, and in a lot of Indian consumer startups a slow-burning source of resentment. The grant letter says 4,000 options. Nobody explains the denominator, the strike price, or what happens if the person leaves in year two. Three years later the company runs a buyback, half the team does the arithmetic for the first time, and trust takes the damage.

The mechanics are not complicated. They are just rarely written down in plain language. Here they are.

Pool sizing and what it really dilutes

The Companies Act sets no cap on pool size. Market practice for early-stage Indian startups is 10 to 15 percent of fully diluted capital. Consumer brands often sit at the lower end, because headcount skews towards supply chain, operations and retail rather than engineering, and equity is a weaker lever in those functions.

The part founders underestimate is refresh. Investors expect a top-up at every round, and the top-up is almost always taken pre-money. Existing shareholders absorb it before the new money lands. A 5 percent top-up at Series A is not shared evenly across the post-round cap table. It comes out of your side.

Two habits help:

• Size the pool against a hiring plan, not a round number. Count the roles you will actually grant to over the next eighteen months and price each band.
• Track pool burn monthly: granted, vested, forfeited, unallocated. A pool that reads 12 percent on the cap table may have under 2 percent left to grant.

Vesting, cliffs and the window that traps people

Four years with a one-year cliff is the Indian norm. Twenty five percent vests at month twelve, the rest monthly or quarterly across the remaining three years. The cliff is a real cliff. A person who leaves at month eleven gets nothing, and that is the intent.

The exercise window is where most plans quietly fail the people holding them. Standard drafting gives leavers 30 to 90 days after exit to exercise vested options. Miss the window and they lapse. So someone who served three years is handed a choice: find cash for the strike plus the tax inside ninety days, against shares they cannot sell, or forfeit the grant.

Most people forfeit. The option looked like compensation and behaved like a bill.

Longer windows are now common for senior grants, often 12 to 24 months, and some companies extend the window to anyone past a tenure threshold. It costs no cash today. It changes what the instrument is worth to the person holding it, and it changes what they tell the next candidate you try to hire.

Strike price and the valuation basis

The exercise price is set by the board under Rule 12(3) of the Companies (Share Capital and Debentures) Rules, 2014. There is no legal requirement that it match fair market value. Early plans often use face value or a nominal strike, which makes exercise cheap and pushes the entire economic gap into the perquisite.

Fair market value is a separate number, determined for an unlisted company by a merchant banker or registered valuer using discounted cash flow, comparable transactions, or the most recent primary round. The taxable perquisite is that value minus the strike. Note the consequence carefully: a high paper valuation raises the tax bill on every exercise that follows, whether or not anyone can sell a share.

Two tax events, and where buybacks sit

There are two separate moments.

• At exercise. The gap between fair market value on the exercise date and the strike is taxed as a perquisite under Section 17(2)(vi), added to salary income at the person’s slab rate. The company withholds TDS. Cash goes out and nothing has been sold.
• At sale. Any gain above the value used at exercise is a capital gain. For unlisted shares held more than 24 months from exercise it is long term. Below that it is short term and taxed at slab.

Eligible DPIIT-recognised startups can defer the perquisite TDS, broadly to the earliest of five years, the employee’s exit, or sale of the shares. The eligibility list is narrower than most founders assume. Confirm your own status before you promise it in an offer letter.

Buybacks are the contested piece. When a company repurchases options that are vested but never exercised, there is a live dispute over whether the payout is salary in the employee’s hands or a capital receipt. Courts have gone different ways on close to the same facts, with the Delhi, Karnataka and Madras High Courts reaching divergent conclusions on Flipkart-related matters. In 2026 a Bengaluru bench of the ITAT held that consideration for vested but unexercised options was not automatically taxable as salary and could fall under long-term capital gains.

Read that carefully. It is a tribunal decision in one taxpayer’s case, it can be appealed, and it does not make the treatment settled law. Do not brief your team on the tax outcome of a buyback. Brief them on the structure, tell them the treatment is contested, and tell them to run their own numbers past their CA. If you are the one running the buyback, get a written withholding position from your advisors before money moves, because getting it wrong creates a company liability and not only an employee problem.

What to fix this quarter

• Publish a one-page explainer with a worked example at a real strike and a real valuation, including the cash tax due at exercise.
• Show every holder their vested count, unvested count and current fair market value once a quarter.
• Extend the leaver exercise window for anyone past two years. Get it board approved and put it in the policy, not in an email.
• Decide your buyback rhythm and say it out loud. Even a clear no buyback before Series C is better than silence.