Employee Stock Option Plans (ESOPs) have become a popular way for startups and growing companies to reward their teams. Instead of giving only cash, employers offer a chance to own part of the company. It motivates employees to stay longer and work harder because they share in the company’s success. In India, ESOPs are now common in startups, IT firms, and even mid-sized businesses. But while ESOPs sound simple, their valuation and tax rules can be confusing. Both founders and employees need to understand how ESOPs are valued and taxed at different stages.
This blog breaks down ESOP valuation and tax implications in easy language so you can make smarter financial and legal decisions.
What Is an ESOP?
An Employee Stock Option Plan (ESOP) gives employees the right to buy company shares at a fixed price, known as the exercise price. The goal is to link employee rewards with company growth.
When the company’s value increases, the employee can buy shares at the old exercise price and sell them later at a higher market price. The profit becomes their gain.
However, this gain also attracts tax, both for the employee and the company, depending on the stage of the ESOP.
Stages of ESOP and When Tax Applies
The ESOPs go through three main stages:
1. Grant Stage:
The company grants the right to the employee. No tax applies at this point.
2. Vesting Stage:
After some time (say, one year or more), the employee earns the right to exercise the option. Still, no tax yet.
3. Exercise and Sale Stage:
When the employee chooses to buy shares (exercise), tax rules start to apply.
Let’s see how.
Tax on ESOPs for Employees
At the time of exercise, employees are taxed on the perquisite value, which is the difference between:
Fair Market Value (FMV) on the exercise date and Exercise Price paid by the employee.
For example:
- FMV (as per a valuer): ₹200 per share
- Exercise Price: ₹100 per share
- Perquisite = ₹100 (₹200 – ₹100)
This ₹100 is considered part of the employee’s salary income and is taxed as per the income tax slab.
This is the stage when ESOPs can feel like a burden because the employee pays tax even before selling the shares.
Later, when the employee sells the shares, capital gains tax applies:
- If shares are held for less than 24 months: Short-term capital gains
- If held for 24 months or more: Long-term capital gains
- The sale price minus the FMV (already taxed earlier) determines this gain.
Tax for Founders or Promoters
ESOP taxation doesn’t only affect employees because founders also face implications. When founders or key executives get ESOPs, they are taxed the same way as other employees.
However, founders often face issues with liquidity. Since they may not sell shares immediately, they must pay tax on notional gains. For startups with unlisted shares, this creates a cash flow problem, paying tax without actually earning real money yet.
To reduce this pain, the government offers tax deferment benefits under Section 80-IAC for eligible startups. In such cases, tax on ESOPs can be delayed until the earliest of these events:
- Five years from exercise,
- Sale of shares, or
- Exit from employment.
This rule applies only if the company qualifies as a “recognised startup” under DPIIT guidelines.
Valuation Rules for ESOPs
The valuation of ESOPs is crucial because tax depends on the Fair Market Value (FMV).
For listed companies, FMV is the average price of shares on the stock exchange on the exercise date.
For unlisted companies, FMV must be determined by a merchant banker or registered valuer as per Rule 3(8) of the Income Tax Rules.
The valuer uses one or more methods, such as:
- Discounted Cash Flow (DCF) method
- Net Asset Value (NAV) method
This independent valuation ensures that the company’s ESOP pricing is fair and compliant with tax laws. It also protects both the employer and employee from future tax disputes.
ESOP Problems and Solutions
ESOPs are particularly well-liked in new businesses because they enable the attraction and retention of talent in the absence of high salaries. Startups have their own challenges, though:
- High tax prior to liquidity events.
- Finding the correct value for early-stage firms is challenging.
- Insufficient legal compliance knowledge.
To manage this, startups frequently hire registered valuers or valuation firms such as Valuation India to accurately calculate the FMV of shares and set up clear ESOP arrangements. This guarantees adherence to the Companies Act, Income Tax, and Startup India guidelines.
Right valuation enables entrepreneurs to prevent under- or over-pricing ESOPs, either of which might create legal or tax issues later on.
How Employees Might Organise Better
Workers getting ESOPs need ahead-of-time planning:
- Have a clear grasp of the vesting schedule and exercise price.
- Under DPIIT, see if your firm is eligible for tax deferral.
- Before working out, estimate the probable tax liability.
- Talk to a tax specialist to time the sale of stocks for reduced capital gains.
- Safeguarding all ESOP grant and exercise paperwork is essential for records.
Early preparation will help staff members maximise ESOPs without being taken aback by taxes.
End Note
In essence, both founders and workers must have ESOP valuation and tax planning. A thorough grasp of regulations guarantees compliance, saves money, and fosters employers’ and employees’ long-term trust.
Reach out to Valuation India if you require professional assistance with ESOP valuing, share pricing, or compliance for startups. For entrepreneurs, founders, and staff members, our team of qualified experts offers precise, regulatory-compliant evaluations. Contact Valuation India right now to obtain an honest, trustworthy ESOP valuation suited to both corporate and tax obligations.