ESOPs Before an IPO: What Survives Listing and What Does Not

By CA Dhruv Seth, Seth & Associates, Chartered Accountants, Lucknow

In most companies preparing to list, the stock option pool is the least documented item on the cap table: grant letters signed years ago, vesting tracked in a spreadsheet, an option held by a co-founder about to be named a promoter. None of it creates friction until the merchant banker's diligence begins.

Why ESOPs before an IPO deserve a hard look

An unlisted company's scheme runs on Section 62(1)(b) of the Companies Act, 2013 read with Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014. From listing, the SEBI (Share Based Employee Benefits and Sweat Equity) Regulations, 2021 take over. Schemes drafted only for the private phase often do not survive that transition unamended, and fixing one after the draft offer document is filed is considerably harder than fixing it before.

What diligence usually turns up:

• Grants made without a valid special resolution, or in excess of the approved pool ceiling

• Vesting shorter than the statutory minimum of one year from grant

• Options issued to independent directors, which is not permitted

• No recorded position on the exercise rights of employees who have resigned

• An option register that does not reconcile to the cap table

The promoter problem, and the 2025 relief

Rule 12(1) bars options to promoters, to the promoter group, and to directors holding more than ten per cent of the outstanding equity directly or indirectly. DPIIT-recognised startups are exempt for ten years from incorporation. Separately, the SBEB Regulations did not allow a listed company's promoters to hold options at all.

This produced a familiar trap. A founder diluted across successive funding rounds would be granted options as an employee; at the DRHP stage the same founder was identified as a promoter, and the grants had to go.

SEBI notified the SBEB (Amendment) Regulations, 2025 on 8 September 2025, inserting Regulation 9A. An employee identified as a promoter or promoter group member in the draft offer document may continue to hold and exercise options, stock appreciation rights or other benefits granted at least one year before the DRHP is filed. The relief is conditional on timing: grants made inside that one-year window do not qualify. Where founder incentives are still being restructured, the intended filing date is now a hard constraint on the grant calendar.

What the merchant banker will test

Expect the scheme to be traced end to end: board approval, shareholder approval, the pool ceiling, ratification after conversion to a public limited company, and alignment to SBEB before listing. The offer document must disclose each scheme, options outstanding, exercise prices and the resulting dilution.

The ICDR Regulations restrict outstanding convertible instruments and rights to receive equity at the time of filing, with options granted to employees under an approved scheme treated as the recognised exception. SEBI's 2025 ICDR amendments also improved the position of stock appreciation rights; companies using SARs or phantom units should confirm the current treatment rather than assume parity with plain options.

Dilution, accounting and the question employees will ask

• The Ind AS 102 fair value charge lands in the restated profit and loss for the periods disclosed. A large grant made shortly before filing visibly depresses the very years investors examine.

• Diluted earnings per share are presented alongside basic. The pool is genuine dilution, not a footnote.

• Employees pay perquisite tax at exercise on the gap between fair market value and exercise price, and capital gains on eventual sale. After listing, an employee exercising during a closed trading window can face a cash tax outflow well before any sale is possible.

The ICDR Regulations permit an employee reservation portion of up to five per cent of post-issue capital, and a discount to the offer price. Per-employee allotment ceilings apply, so it is a goodwill measure, not a substitute for a properly designed pool.

Key takeaways

• Clean the scheme before the DRHP, never after

• If a founder will be named a promoter, complete the grant at least one year ahead of filing

• Reconcile the option register, the cap table, the accounting charge and the offer document to a single number

• Budget for the Ind AS 102 charge in the restated years

• Tell employees, in writing, what exercise will cost in tax and when they can realistically sell

This article is for general information and does not constitute investment, legal or tax advice. Regulations change; please verify the current position or speak to a qualified adviser before acting.