Constituents of an ESOP Policy: Framework, Structure, and Key Components

1. Introduction

Employee Stock Option Plans (ESOPs) have evolved from a niche compensation tool into one of the most powerful instruments for aligning the interests of founders, investors, and employees in modern startups. In an environment where cash-strapped companies compete for world-class talent, ESOPs bridge the gap between what a startup can afford today and the value it promises to create tomorrow.

However, an ESOP is only as effective as the policy that governs it. A well-drafted ESOP policy provides clarity on how options are granted, how they vest, what happens when an employee leaves, and how value is realised during a liquidity event. Without a structured policy, ESOPs can become a source of confusion, disputes, and misaligned expectations for both founders and employees.

This article examines the essential constituents of an ESOP policy, offering a practical framework for founders designing their plans and employees evaluating the options they receive. The objective is to demystify the structure of ESOP policies so that every stakeholder can make informed decisions.

Summary

An ESOP policy is the governing document that defines how stock options are granted, vested, exercised, and treated under various scenarios in a company. This article covers the key constituents of an ESOP policy—including eligibility criteria, vesting schedules, exercise pricing, leaver provisions, exit treatment, and taxation—to help startup founders design effective plans and employees evaluate the options they receive.

2. What Is an ESOP Policy?

Definition

An ESOP policy is a formal document adopted by a company that sets out the rules, terms, and conditions governing the grant, vesting, exercise, and treatment of stock options issued to eligible employees.

The ESOP policy serves as the master framework under which individual option grants are made. It is typically approved by the board of directors and, where required by law (as in India under the Companies Act, 2013), by shareholders through a special resolution.

ESOP Pool vs. ESOP Policy

It is important to distinguish between the ESOP pool and the ESOP policy. The ESOP pool refers to the total number of shares (or the percentage of equity) that a company has reserved for issuance under its stock option programme. It represents the quantum of equity set aside. The ESOP policy, on the other hand, is the governing document that lays down how options from that pool are allocated, vested, exercised, and treated under various scenarios.

For a detailed understanding of how ESOP pools are structured and sized, refer to the article Understanding ESOP Pools: Building Equity for Employees.

In essence, the pool is the reservoir; the policy is the plumbing that determines how the water flows.

3. Core Framework of an ESOP Policy

A typical ESOP policy is structured around several interlocking components that together create a complete lifecycle for stock options. While the specific language and clauses vary across jurisdictions and company stages, most ESOP policies follow a common architecture:

1. Preamble and Objectives: States the purpose of the plan, the company’s philosophy on equity compensation, and the governing law.

2. Definitions: Defines key terms such as “Option,” “Vesting Date,” “Exercise Price,” “Good Leaver,” and others used throughout the policy.

3. Eligibility and Grant Framework: Specifies who can receive options and the mechanics of granting them.

4. Vesting and Cliff Provisions: Sets out the schedule on which options become exercisable.

5. Exercise Mechanics: Details the process, pricing, and timeline for converting options into shares.

6. Leaver and Forfeiture Provisions: Addresses what happens to vested and unvested options when an employee departs.

7. Corporate Event Provisions: Covers treatment of options during mergers, acquisitions, IPOs, or restructuring.

8. Transfer Restrictions and General Terms: Governs transferability, tax treatment references, and administrative provisions.

Each of these components is examined in detail in the following section.

4. Key Constituents of an ESOP Policy

4.1 Total ESOP Pool Size

The ESOP policy typically begins by referencing the total pool size, which is the aggregate number of options (or shares) available for grant under the plan. This figure is usually expressed as a percentage of the company’s fully diluted share capital. Common pool sizes range from 5% to 20%, depending on the stage and industry of the company.

The policy should specify the maximum number of options that may be granted under the plan and the mechanism for increasing the pool (which usually requires fresh shareholder approval). Pool size directly impacts dilution for existing shareholders, making it a critical negotiation point during funding rounds.

4.2 Eligibility Criteria

Not every individual associated with a company may be eligible for ESOPs. The policy must clearly define who qualifies. Common eligibility categories include:

• Permanent employees of the company (full-time)

• Directors (including whole-time directors but often excluding independent directors and promoter directors, particularly under Indian law)

• Employees of subsidiary or holding companies, where the plan is extended to the group

The policy may also specify exclusions, such as consultants, advisors, or employees who have not completed a minimum service period. In India, Section 62(1)(b) of the Companies Act, 2013, read with Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014, sets out the eligibility framework for listed and unlisted companies.

4.3 Grant Mechanics

The grant is the formal act of offering stock options to an eligible employee. The ESOP policy should detail:

• Authority to grant: Typically the board of directors or a designated compensation committee.

• Grant letter: A written document issued to each grantee specifying the number of options, exercise price, vesting schedule, and other individual terms.

• Acceptance process: Whether the employee must formally accept the grant within a specified period.

• Conditions for grant: Performance criteria, tenure milestones, or other preconditions that may apply.

The grant date is significant because it often determines the exercise price and starts the clock on vesting periods.

4.4 Vesting Schedule

What Is Vesting?

Vesting is the process by which an employee earns the right to exercise their stock options over time. Until options vest, the employee holds a promise but cannot act on it.

The most common vesting structure in the startup ecosystem is time-based vesting over four years, though performance-based vesting and milestone-based vesting are also used. A typical schedule for 1000 options might look like this:

Year	Cumulative Vesting	Options Vested	Status
Year 1 (Cliff)	25%	250 of 1,000	First tranche vests
Year 2	50%	250 additional	Quarterly/monthly vesting
Year 3	75%	250 additional	Quarterly/monthly vesting
Year 4	100%	250 additional	Fully vested

Some companies adopt graded vesting (unequal portions each year), back-loaded vesting (larger portions in later years to incentivise longer tenure), or performance-linked vesting tied to specific KPIs or company milestones.

4.5 Cliff Period

What Is a Cliff?

A cliff period is the minimum duration an employee must complete before any options vest. If the employee leaves before the cliff, all granted options are forfeited.

The standard cliff in most startup ESOP plans is one year. This protects the company from granting equity to employees who leave shortly after joining. After the cliff, vesting typically continues on a monthly or quarterly basis for the remaining period.

4.6 Exercise Price

What Is the Exercise Price?

The exercise price (also called the strike price) is the price an employee must pay to convert each vested option into a share of the company.

The ESOP policy should specify how the exercise price is determined. For unlisted companies, there is no statutory requirement under the Companies Act, 2013, to set the exercise price at any particular level. The board or compensation committee may set it at:

• Face value (par value) of the shares

• Fair Market Value (FMV) at the date of grant, as determined by a registered valuer

• Any other price decided by the company, including a discount to FMV or a premium, based on the company’s compensation philosophy

While unlisted companies have flexibility in setting the exercise price, the pricing decision has direct tax consequences. At the time of exercise, the difference between the fair market value of the shares (determined under Rule 11UA of the Income Tax Rules, 1962) and the exercise price paid by the employee is treated as a perquisite and taxed as income from salary. A lower exercise price therefore results in a higher perquisite value and greater tax liability at exercise. This trade-off between employee incentive and tax impact is an important consideration in startup ESOP design.

4.7 Exercise Period

The exercise period is the window of time during which an employee can exercise their vested options. The policy should clearly define:

• The start date (typically the vesting date for each tranche)

• The end date (a fixed number of years from the grant or vesting date)

• Whether the exercise period changes in the event of termination (discussed further under leaver provisions)

If vested options are not exercised within the exercise period, they typically lapse and are returned to the ESOP pool. Some policies allow a post-termination exercise window of 30 to 90 days, while others may extend this for good leavers.

4.8 Lock-in Provisions

Once options are exercised and shares are allotted, some ESOP policies impose a lock-in period during which the employee cannot sell or transfer the shares. Lock-in provisions serve several purposes:

• Aligning employee interests with long-term company performance

• Preventing immediate sell-offs that could destabilise the cap table

• Meeting regulatory requirements where applicable (for listed companies in India, SEBI regulations may prescribe lock-in requirements depending on the applicable framework and the specific circumstances of the issuance)

The policy should specify the duration of the lock-in, any exceptions (such as permitted transfers to family trusts), and what happens to locked-in shares in the event of a corporate action.

4.9 Leaver Provisions: Good Leaver vs. Bad Leaver

Leaver provisions are among the most consequential clauses in any ESOP policy. They determine what happens to an employee’s options—both vested and unvested—when the employment relationship ends.

Good Leaver

A “good leaver” is typically an employee who departs under favourable or neutral circumstances, such as:

• Voluntary resignation after a minimum tenure

• Retirement

• Redundancy or retrenchment

• Death or permanent disability

Good leavers usually retain their vested options and are given a reasonable exercise window (often 3 to 12 months) after departure. Unvested options are typically forfeited.

Bad Leaver

A “bad leaver” is generally an employee who is terminated for cause, such as:

• Misconduct or fraud

• Breach of employment agreement or non-compete obligations

• Termination for cause

Bad leavers typically forfeit all options—both vested and unvested—or may be required to sell back exercised shares at the lower of cost or fair market value. These provisions must be drafted carefully to balance enforceability with fairness.

4.10 Treatment During Exit or IPO

One of the primary motivations for holding ESOPs is the prospect of a liquidity event. The policy should clearly address:

• Accelerated vesting: Whether some or all unvested options vest upon an exit event (full or partial acceleration)

• Cashless exercise: Whether employees can exercise options using proceeds from the exit itself, rather than paying upfront

• Tag-along and drag-along rights: Whether ESOP holders participate in a sale alongside other shareholders

• IPO lock-up: Whether exercised shares are subject to a post-IPO lock-up period, as is common practice and often required by stock exchange regulations

Clear exit provisions prevent disputes at the most critical moment in a company’s lifecycle and ensure employees understand the value they stand to receive.

4.11 Corporate Actions

The ESOP policy must address how options are treated when the company undergoes significant structural changes. Common corporate actions include:

• Mergers and acquisitions: Whether options are assumed by the acquiring entity, converted into equivalent options of the acquirer, or cashed out

• Demergers and spin-offs: How options are allocated between the resulting entities

• Stock splits and bonus issues: Proportional adjustment of the number of options and exercise price

• Capital restructuring: Treatment during rights issues, buybacks, or changes in share capital

These provisions are often referred to as “adjustment clauses” and are essential for ensuring that the economic value of options is preserved through corporate events.

4.12 Transferability and Restrictions

In most ESOP frameworks, stock options are personal to the grantee and cannot be transferred, pledged, assigned, or encumbered. This is both a contractual restriction under the policy and, in many jurisdictions, a statutory requirement. In India, for instance, the Companies Act expressly provides that options granted to employees are non-transferable.

The policy should address limited exceptions, such as transmission on death to legal heirs or nominees, and make clear that any attempted transfer in violation of the policy renders the options void.

4.13 Taxation Overview

Note

Tax treatment of ESOPs varies by jurisdiction and individual circumstances. The following is a general overview and not tax advice. Employees and companies should consult qualified tax advisors for guidance specific to their situation.

ESOPs generally attract tax at two distinct stages:

• At exercise: The difference between the fair market value (FMV) of the shares on the date of exercise and the exercise price paid by the employee is treated as a perquisite and taxed as income from salary. For instance, if the FMV at exercise is 500 per share and the exercise price is 10, the perquisite value is 490 per share.

• At sale: The difference between the sale price and the FMV of the shares at the time of exercise is treated as a capital gain. The applicable tax rate depends on the holding period (short-term or long-term) and the nature of the shares (listed or unlisted).

  
  

For eligible startups recognised under the Department for Promotion of Industry and Internal Trade (DPIIT) framework, tax on the perquisite at the time of exercise may be deferred. Under Section 17(2)(vi) of the Income Tax Act, 1961, the deferred tax becomes payable on the earliest of the following events:

• Expiry of 48 months from the end of the relevant assessment year in which the options were exercised

• The date of sale of the shares by the employee

• The date on which the employee ceases to be employed by the eligible startup

The ESOP policy itself does not usually contain detailed tax advice but should reference the employee’s responsibility to understand and comply with applicable tax obligations.

5. Typical ESOP Lifecycle

Understanding the lifecycle of an ESOP helps both founders and employees see the complete picture. The journey from grant to realisation follows four key stages:

Stage 1: Grant

The company issues a grant letter to the employee specifying the number of options, exercise price, vesting schedule, and other terms. The employee may need to formally accept the grant. No shares are issued at this stage, and no tax event typically occurs.

Stage 2: Vesting

Options vest over time according to the schedule defined in the policy. Once an option vests, the employee earns the right to exercise it but is not obligated to do so. Unvested options remain contingent on continued employment (and, in some cases, performance conditions).

Stage 3: Exercise

The employee pays the exercise price and converts vested options into actual shares of the company. This is when the first tax event occurs: the difference between the FMV of the shares on the exercise date and the exercise price is taxed as a perquisite (income from salary). After exercise, the employee becomes a shareholder with all associated rights, subject to any lock-in or transfer restrictions.

Stage 4: Exit or Sale

The employee realises the value of their shares through a liquidity event, such as a secondary sale, buyback, IPO, or acquisition. The second tax event (capital gains) occurs at this stage. The difference between the sale price received and the FMV of the shares at the time of exercise is treated as a capital gain, with the tax rate depending on the holding period and the nature of the shares.

6. How Startups Should Design Their ESOP Policy

Strategic Considerations

• Align the pool size with hiring plans. Reserve enough equity to attract talent across multiple rounds of hiring without requiring frequent shareholder approvals for pool expansion.

• Benchmark against industry standards. ESOP allocations vary by role, seniority, and stage. Early employees typically receive larger grants relative to later hires.

• Consider investor expectations. Investors often have views on acceptable pool sizes and vesting structures. These should be discussed during term sheet negotiations.

• Plan for liquidity. Employees increasingly expect periodic liquidity opportunities (buybacks or secondary sales) rather than waiting for an IPO. The policy should accommodate this.

Common Mistakes

• Vague leaver provisions: Ambiguity in good leaver and bad leaver definitions leads to disputes and litigation.

• Ignoring tax implications: Setting the exercise price significantly below FMV without considering tax consequences can create a large perquisite value, resulting in an unexpected tax burden for employees at the time of exercise.

• Overly restrictive exercise windows: Giving departing employees only a few days to exercise vested options effectively converts the ESOP into a retention handcuff rather than a wealth-sharing tool.

• Failing to communicate: An ESOP policy that employees do not understand has limited motivational value. Clear communication and education are essential.

Balancing Dilution and Incentives

Every ESOP grant dilutes existing shareholders. Founders must balance the need to attract and retain talent with the imperative to preserve ownership and meet investor expectations. This is not a one-time decision but an ongoing calibration that evolves as the company grows. A well-structured policy, with clear eligibility criteria and a disciplined grant framework, helps manage this balance.

7. What Employees Should Check in an ESOP Policy

Employees receiving an ESOP grant should review the underlying policy carefully. Key clauses that directly affect the real value of the grant include:

• Vesting schedule and cliff: Understand when options actually become exercisable and what happens if you leave before the cliff.

• Exercise price: Know the price you will need to pay and how it compares to the current fair market value of the shares.

• Exercise window after departure: Check how long you have to exercise vested options if you leave the company. A 30-day window is very different from a 5-year window.

• Leaver classification: Understand the definitions of good leaver and bad leaver, and what triggers each classification.

• Liquidity path: Ask about the company’s plans for providing liquidity, whether through buybacks, secondary sales, or an eventual IPO.

• Lock-in restrictions: Even after exercising, you may not be able to sell shares immediately. Understand the duration and terms of any lock-in.

• Tax liability: Seek independent tax advice to understand the tax implications at the time of exercise and at the time of sale.

• Acceleration on exit: Determine whether unvested options accelerate in the event of an acquisition or IPO, and to what extent.

An informed employee is better positioned to negotiate meaningful terms and to make decisions about accepting, exercising, or holding options.

8. Conclusion

A well-structured ESOP policy is far more than a legal formality. It is the backbone of a company’s equity compensation programme and a reflection of its values around shared ownership and long-term alignment. For founders, it is a strategic tool that must balance dilution, regulatory compliance, and talent incentives. For employees, it represents a potential pathway to meaningful wealth creation, but only if the underlying terms are fair, transparent, and well-understood.

The constituents discussed in this article—from pool size and eligibility to leaver provisions and exit treatment—form the building blocks of any robust ESOP framework. Getting these right at the outset prevents costly disputes later and ensures that the ESOP programme delivers on its promise of aligning interests across the organisation.

Whether you are designing a plan or evaluating one, the emphasis should always be on clarity, alignment, and long-term thinking.

Frequently Asked Questions

1. What is the difference between an ESOP pool and an ESOP policy?

The ESOP pool is the total quantum of equity reserved for issuance to employees, usually expressed as a percentage of fully diluted capital. The ESOP policy is the governing document that defines the rules for granting, vesting, exercising, and treating those options. The pool determines how much equity is available; the policy determines how it is distributed and managed.

2. Is shareholder approval required for an ESOP policy in India?

Yes. Under the Companies Act, 2013, the implementation of an ESOP scheme requires approval by shareholders through a special resolution. Additionally, the explanatory statement annexed to the notice of the general meeting must contain specific prescribed disclosures about the scheme.

3. What is a typical vesting schedule for startup ESOPs?

The most common structure is four-year vesting with a one-year cliff. After the cliff, 25% of the options vest, and the remaining 75% vest on a monthly or quarterly basis over the next three years. However, variations are common depending on the company’s objectives and the seniority of the grantee.

4. Can stock options be transferred to another person?

In general, no. ESOP options are personal to the grantee and are non-transferable under most policies and applicable laws. Limited exceptions may exist for transmission to legal heirs upon the death of the option holder.

5. What happens to unvested options if an employee resigns?

Unvested options are typically forfeited upon resignation. The treatment of vested options depends on the leaver provisions of the policy. A “good leaver” usually retains vested options and receives a window to exercise them, while a “bad leaver” may forfeit vested options as well.

6. When is tax payable on ESOPs in India?

Tax arises at two stages. First, at the time of exercise, the difference between the fair market value of the shares and the exercise price paid is taxed as a perquisite under income from salary. Second, at the time of sale, the difference between the sale price and the FMV at the time of exercise is taxed as a capital gain. For eligible DPIIT-recognised startups, the perquisite tax at exercise may be deferred until the earliest of: (a) 48 months from the end of the relevant assessment year, (b) the date of sale of the shares, or (c) the date the employee ceases employment with the startup.

7. Should early-stage employees negotiate their ESOP terms?

Yes. Early-stage employees often take on significant risk by joining a startup at a nascent stage, and the ESOP grant is a key component of their total compensation. Employees should seek clarity on the exercise price, vesting terms, leaver provisions, and liquidity expectations before accepting a grant. Understanding these terms ensures that the equity component of compensation is meaningful and not merely symbolic.