The life of an option
An employee stock option travels through a clear lifecycle: the company adopts a scheme, grants options to an individual, those options vest over time, the employee exercises the vested ones by paying for them, and only then do actual shares appear. Keeping these stages distinct is the key to understanding ESOPs, because an option is a right to buy shares later, not a share today.
The grant letter
The relationship starts with a grant letter, the individual offer made under the umbrella scheme. A well-drafted grant letter states the number of options, the exercise price (also called the strike price) at which shares can later be bought, the grant date, the vesting schedule, the exercise window, and what happens if the person leaves. At this point the employee owns no shares and has no voting rights. They hold a promise.
Vesting
Vesting is the process by which options are earned over time, commonly across four years with a one-year cliff. Under Rule 12(6)(a) of the Companies (Share Capital and Debentures) Rules, 2014, there must be a minimum of one year between grant and vesting, so no options can vest in the first year. Unvested options are simply not yet earned and can be lost on departure.
Exercise and the exercise window
To turn vested options into shares, the employee must exercise them, which means paying the exercise price to the company. Until that payment happens there are still no shares and no shareholder rights. The scheme defines the exercise window, the period during which vested options may be exercised. While a person is employed this window is often long. On leaving, a limited post-termination window is typical, and the company has the freedom under Rule 12 to set the exercise period and any lock-in.
What happens when an employee leaves
Departure is where many ESOPs are quietly lost, so the rules deserve attention.
- Unvested options almost always lapse immediately on exit. Only what has vested is in play.
- Vested options must be exercised within the post-termination exercise window, or they too lapse. An employee who cannot fund the exercise cost in that window can forfeit real value.
- Schemes often distinguish a good leaver from a bad leaver, so that, for example, termination for cause can forfeit even vested options.
The tax the employee must plan for
ESOPs are taxed in India at two moments. At exercise, the difference between the fair market value of the shares on the exercise date and the exercise price is taxed as a perquisite, that is, as salary income under Section 17(2)(vi) of the Income-tax Act, with the employer deducting TDS under Section 192. At sale, any further gain over that fair market value is taxed as capital gains.
There is important relief for startups. An employee of an eligible startup that is DPIIT recognised and certified under Section 80-IAC can defer the perquisite tax under Section 192(1C) to the earliest of three events: 48 months from the end of the relevant assessment year, the date the shares are sold, or the date the employee leaves. This is a timing benefit only and does not reduce the amount owed. Founders should explain this clearly, because a tax bill at exercise on shares that cannot yet be sold is one of the most common and painful surprises for ESOP holders.