Managing Employee Equity in India: A Comprehensive Guide

Equity awards have become a cornerstone of compensation strategies, especially within India's thriving startup ecosystem. These awards provide employees with more than just a salary—they offer a tangible stake in the company's future, making them a powerful tool for attracting, retaining, and motivating top talent.

In India, equity awards, particularly through Employee Stock Option Plans (ESOPs), are gaining significant recognition.

According to a report by Siason Capital, nearly 62% of companies in India have implemented ESOPs. 87% of these founders believe issuing ESOPs helps in talent retention. ^[Source]

State of employee stock options (ESOPs) in India

In the first quarter of 2024, seven startups in the Indian ecosystem conducted ESOP buybacks. 

While four of these startups have not yet disclosed their deal sizes, Meesho led with a substantial buyback of $24 million. Pocket FM and The Sleep Company followed with buybacks of $8.3 million and approximately $0.3 million, respectively.

In May 2024, Urban Company announced its largest-ever ESOP buyback, valued at around $24.5 million. As of now, more than $56 million in buybacks have been announced in 2024

According to TheKredible, from 2020 to 2023, more than 80 startups have bought back ESOPs worth $1.46 billion. Flipkart alone contributed over 50% of this total. ^[Source]

Other companies, including Swiggy, Log9 Materials, Perfios, CarDekho, Zypp, and BetterHalf, also launched ESOP buyback or liquidity programs in 2023.

In 2023, the total ESOP buyback and liquidity reached nearly $802 million, up from $440 million in 2021 and $200 million in 2022. ^[Source]

The decline in ESOP buybacks in 2022, compared to 2021, mirrors the slowdown in startup funding. In 2021, Indian startups raised a record $38 billion, which fueled buyback activity. However, with a reduction in funding in 2022, the volume and value of ESOP buybacks also saw a significant drop.

That said, since 2020, ~670 IPOs have happened in India. ^[Source]

When a company goes public, it often creates more liquidity for its employees' stock options.

Employees can sell their shares on the public market, reducing the need for the company to conduct ESOP buybacks. This could explain why some startups might have fewer buybacks during a period when IPO activity is high.

ESOPs, RSUs, and SARs in India

1. ESOPs

a. Mechanics

i. Right to purchase: Stock options grant employees the right to buy company shares at a predetermined price, known as the exercise or strike price.

ii. Vesting period: These options typically come with a vesting period, during which employees must stay with the company or meet specific performance milestones. Only after the vesting period can employees exercise their options.

A common vesting schedule in India is four years, with a one-year cliff, where no options vest in the first year, and then the remaining options vest monthly or quarterly over the next three years.

iii. Exercise: Once vested, employees can purchase shares at the agreed-upon exercise price, regardless of the current market value. This offers a potential financial benefit if the market price of the shares has increased.

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b. Tax implications on employee stock options

i. At exercise: The difference between the exercise price and the Fair Market Value (FMV) of the shares on the exercise date is considered taxable income and is treated as a perquisite under the Income Tax Act.

Example

Imagine you have been granted 1,000 Employee Stock Options (ESOPs) with an exercise price of ₹50 per share. The Fair Market Value (FMV) of the shares on the exercise date is ₹150 per share.

‍Calculation

• Exercise Price: ₹50 per share
• Fair Market Value (FMV): ₹150 per share
• Taxable Income = (FMV - Exercise Price) × Number of Shares

Taxable Income = (₹150 - ₹50) × 1,000

Taxable Income = ₹100 × 1,000

Taxable Income = ₹1,00,000

Even though you have not sold the shares or received cash, the ₹1,00,000 is considered a perquisite and is taxed as part of your salary income. This is reported by your employer in your Form 16, and you must pay tax on this amount in the relevant financial year.

ii. At sale: When the shares acquired through stock options are sold, capital gains tax applies to the difference between the sale price and the FMV at the time of exercise.

Example

• Sale price: ₹200 per share
• FMV at exercise: ₹150 per share
• Capital gain per share: ₹200 - ₹150 = ₹50 per share

Total capital gain = capital gain per share × number of shares sold

Total capital gain = ₹50 × 1,000

Total capital gain= ₹50,000

Short-term capital gains: If the shares are sold within one year of exercise, the gains are taxed at 20%, showing an increase from the previous rate of 15% after the Budget 2024 announcement.‍

Long-term capital gains: If the shares are held for more than a year, the gains are taxed at 12.5%, up from the previous rate of 10%, following the Budget 2024 announcement. 

This rate applies to gains exceeding ₹1.25 lakh, which is the threshold for total long-term capital gains tax exemption in each fiscal year for all assets, not just for equity compensation sale.

2. Restricted Stock Units (RSUs)

a. Mechanics

i. Nature of RSUs: RSUs represent a grant of company shares (not options) given to employees, which they receive outright after meeting certain vesting conditions. Unlike stock options, which require employees to buy shares at a predetermined price, RSUs do not involve a purchase price.

ii. Vesting: RSUs vest over a specified period or based on performance goals. Once vested, the employee is granted actual shares of the company.

iii. Delivery: Upon vesting, the shares are delivered to the employee, who then owns them outright without any additional cost.

b. Tax implications on RSUs

i. At vesting: RSUs are taxed as perquisites under the Income Tax Act. The value of the shares at the time of vesting is considered taxable income.

Example

• Number of RSUs granted: 1,000 shares
• Fair market value (FMV) at vesting: ₹200 per share

Taxable income = Number of RSUs × FMV per share

Taxable income = 1,000 shares × ₹200

Taxable income = ₹2,00,000

Even though you haven't sold the shares yet or received any cash, you are still liable to pay tax on the value of the shares at the time they vest. This taxable amount is reported in your income and taxed accordingly.

ii. At sale: When RSU shares are sold, capital gains tax applies to the difference between the sale price and the Fair Market Value (FMV) at vesting.

When these shares are later sold, any profit earned is subject to capital gains tax. The capital gain is calculated as the difference between the sale price and the FMV at the time of vesting.

This gain is taxed as either short-term or long-term capital gains depending on the holding period, similar to employee stock options.

3. Stock Appreciation Rights (SARs)

a. Mechanics

i. Nature of SARs: SARs grant employees the right to receive the monetary value equivalent to the increase in the company’s share price over a predetermined period.

Unlike stock options, SARs do not require employees to purchase shares. Instead, employees are compensated for the increase in share value, either in cash or stock.

ii. Vesting: SARs vest over a specified period or upon achieving performance goals. Once vested, employees can exercise their SARs to claim the appreciation value based on the rise in the company’s share price.

iii. Settlement: Upon exercise, SARs are settled by paying the employee the difference between the grant price (the price at which SARs were issued) and the current market price.

Settlement can be made in cash, company shares, or a combination of both.

b. Tax implications on SARs

i. At exercise: The appreciation received from SARs is treated as taxable income. If settled in cash, the entire amount is taxed as perquisites (similar to salary income). If settled in shares, the value of the shares at the time of exercise is considered taxable income.

Example

An employee has SARs with a grant price of ₹100 per share. At the time of exercise, the market price is ₹200 per share. The employee has 1,000 SARs.

In case of cash settlement

Appreciation calculation: The appreciation per share is ₹200 (market price) - ₹100 (grant price) = ₹100.

Total appreciation: For 1,000 SARs, the total appreciation is ₹100 x 1,000 = ₹1,00,000.

‍Tax treatment: The entire ₹1,00,000 is treated as taxable income. It’s taxed as perquisites (similar to salary income) at the employee’s applicable income tax rate.

In case of share settlement

Appreciation calculation: The appreciation per share remains ₹100, so for 1,000 SARs, the total appreciation is ₹1,00,000.

Tax treatment at exercise: The value of the shares at the time of exercise is ₹200 per share. Therefore, the taxable income is calculated based on this value.

Taxable income: 1,000 shares x ₹200 = ₹2,00,000.

This ₹2,00,000 is treated as taxable income at the time of exercise.
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ii. At sale: Capital gains tax applies when shares are sold, calculated on the difference between the sale price and the FMV at the time of exercise.

TDS deduction on equity compensation in India

When an employee exercises any equity compensation, such as ESOPs, RSUs, or SARs, the employer is required to deduct Tax Deducted at Source (TDS) on the perquisite value under Section 192 of the Income Tax Act. This TDS is then reported in the employee's Form 16 and included as part of their salary income in their tax return.

Since equity compensation is often in the form of shares, employers must manage TDS differently compared to monetary compensation:

i. Direct payment: The employee is asked to transfer the TDS amount to the company's account via bank transfer.

ii. Sell-to-cover: More commonly, the employer performs a sell-to-cover transaction, where a portion of the allotted shares is sold to cover the TDS amount.

What is the best vesting schedule?

The ideal vesting schedule aligns with the company's goals and the employees' needs.

A common choice is a four-year vesting schedule with a one-year cliff. This means employees must remain with the company for one year before any shares vest.

After the cliff, shares vest gradually over the next three years, often on a monthly or quarterly basis. This structure balances the company’s goal of retaining talent with the employee’s need for equitable compensation.

Vesting methods after the one-year cliff:

1. Linear vesting

Shares vest evenly over the remaining period.

For example, in a four-year schedule with 4,800 shares, 1,200 shares vest after the first year (completion of the cliff).

The remaining 3,600 shares then vest evenly over the next three years, at a rate of 225 shares quarterly or 75 shares monthly.

2. Back-weighted vesting

In a back-weighted vesting schedule, a larger portion of the equity vests later in the vesting period. This rewards long-term commitment by providing more substantial benefits towards the end of the schedule.

For an equity grant of 4,800 shares, a back-weighted schedule might look like this:

• Year 1: 480 shares vested (10% of the total equity award)
• Year 2: 960 shares vested (20% of the total equity award)
• Year 3: 1,440 shares vested (30% of the total equity award)
• Year 4: 1,920 shares vested (40% of the total equity award)

‍Laws governing stock options in India

In India, the Companies Act of 2013 and the Companies (Share Capital and Debentures) Rules of 2014 outline the legal requirements for issuing equity to employees of private companies. ^[Source]

Listed companies must also comply with the Securities and Exchange Board of India (SEBI) Rules 21. ^[Source]

While initially, the Indian company law only officially recognized Employee Stock Option Plans (ESOPs) and sweat equity as stock-related compensation methods. Later, the Ministry of Corporate Affairs, in a report by the Company Law Committee from March 2022, suggested that:

"RSUs (Restricted Stock Units) and SARs (Stock Appreciation Rights) should be officially recognized under the Companies Act, 2013.

If a company needs to issue new shares for these schemes, it should only be done with shareholder approval through a special resolution. However, if these rights don't involve issuing or converting into shares, shareholder approval isn't necessary."

Who is eligible for ESOPs?

According to the 2014 Companies Rules, the following individuals are eligible for ESOPs ^[Source]:

• Permanent employees of the company (in India or abroad)
• Directors of the company (full-time or part-time, but not independent directors)
• Permanent employees or directors of subsidiary or holding companies, either in India or abroad

Who is not eligible for ESOPs?

• Promoters or members of the promoter group
• Directors who hold more than 10% of the company’s outstanding equity shares

Startup exemption: Startups registered under the “Startup India Initiative” are exempt from the above restrictions for ten years from their incorporation.

A startup is defined as a company whose annual turnover is under ₹100 crore in any financial year and the company should focus on innovation, intellectual property, and developing new products with strong potential for job creation.

Who is eligible for sweat equity?

• Permanent employees of the company (in India or abroad)
• A director who is employed as a full-time or executive director of the company.
• Employees or directors of subsidiary or holding companies

What are some necessary disclosures for ESOPs and sweat equity?

a. ESOP disclosures

When a company seeks to grant ESOPs, it must disclose the following details in the explanatory statement attached to the notice for passing the special resolution:

1. Total number of stock options: The company must specify the total number of stock options to be granted.

2. Eligible employees: The identified class of employees who are eligible to participate in the ESOP.

3. Vesting period requirements: The conditions and duration of the vesting period for the ESOPs.

4. Maximum vesting period: The maximum time frame within which the options can vest.

5. Exercise price and process: The price at which the options can be exercised and the procedure for doing so.

6. Lock-in period: Details of any lock-in period, if applicable.

7. Exercise period and process: The timeframe and procedure for exercising the vested options.

8. Maximum options per employee: The maximum number of options that can be granted to each employee and in aggregate.

9. Valuation methods: The methods used by the company to value its stock options.

10. Lapse conditions: The conditions under which vested options may lapse, such as termination of employment due to misconduct.

11. Exercise period in case of termination or resignation: The specific time within which an employee must exercise their vested options if their employment is terminated or they resign.

12. Compliance with accounting standards: A statement confirming that the company will adhere to applicable accounting standards.

b. Sweat equity

When issuing sweat equity, a company must disclose the following information at the time of the general meeting:

1. Total number of shares: The total number of shares to be issued as sweat equity.

2. Eligible directors or employees: The class or classes of directors or employees eligible for the sweat equity shares.

3. Principal terms and conditions: The key terms and conditions, including the basis of valuation for issuing sweat equity shares.

4. Duration of association: The length of time the individual has been associated with the company.

5. Names and relationships: The names of the directors or employees receiving the sweat equity shares and their relationships with the promoters and/or key managerial personnel.

6. Issue price: The price at which the sweat equity shares are proposed to be issued.

7. Consideration received: The consideration, including any non-cash consideration, to be received in exchange for the sweat equity shares.

8. Managerial remuneration: Details on whether the issuance of sweat equity will exceed any ceilings on managerial remuneration and how the company plans to address it.

9. Compliance with accounting standards: A statement ensuring that the company will conform to applicable accounting standards.

10. Diluted earnings per share: Information on how diluted earnings per share will be calculated following the issuance of sweat equity shares, in accordance with applicable accounting standards.

Startup exemption: Startups can issue sweat equity shares up to 50% of their paid-up capital for up to five years from the date of incorporation.

What are the rules for foreign companies giving equity awards to employees in their Indian entities?

When foreign companies grant equity awards to employees in their Indian subsidiaries, they must navigate specific regulations to ensure compliance.

‍1. Overseas Portfolio Investment (OPI)

Effective Aug 2022, equity awards granted by a foreign company to its Indian employees are considered an Overseas portfolio investment (OPI). This classification means that the Indian subsidiary must follow the new Indian overseas investment (OI) Regulations. ^[Source]

Previously, the LRS rules applied to the acquisition and holding of shares in a foreign company. ^[Source]

However, with the new regulations, these transactions are now governed by the OI Rules.

2. Compliance requirements

Uniform offering: The equity awards must be offered on the same terms as those provided to employees in other countries where the foreign company operates. This ensures a level playing field globally.

Reporting: The Indian entity is required to submit semi-annual reports on Form OPI to the Reserve Bank of India (RBI) through its authorized dealer bank. These reports must be filed within 60 days after the end of March and September.

3. Repatriation rules

For holdings less than 10%:  Employees who acquire shares representing less than 10% of the company’s total share capital must repatriate any proceeds from these shares within 180 days of receiving them.

Alternatively, they can reinvest these proceeds within the same period to comply with the regulations.

For holdings 10% or more: If employees hold 10% or more of the company’s share capital, they must repatriate proceeds within 90 days.

Repatriation is the process of bringing money or assets earned abroad back to your home country. 

For example, if an employee in India sells shares or receives dividends from a foreign company, they may need to bring the proceeds back to India, converting the amount into Indian rupees.
The rules governing how quickly this money must be brought back, and any taxes or regulations that apply, are part of repatriation laws.

Note: If an Employer of Record (EOR) is used to manage employment in India, there may be additional local regulations or different compliance requirements to consider.

Using an EOR to manage employment in India means that the EOR takes on the responsibility of ensuring compliance with local regulations, including those related to equity awards. The EOR must navigate any additional or differing requirements that apply to equity compensation under Indian law, which could include specific reporting, taxation, and repatriation processes.

Managing employee equity in India is a nuanced and evolving landscape, especially within the dynamic startup ecosystem. As equity awards like ESOPs, RSUs, and SARs become integral to compensation strategies, companies must navigate complex tax implications, legal frameworks, and best practices to maximize their effectiveness.