How to Design an ESOP for Startups in 2025: A Founder's Ultimate Guide

How to design an ESOP for startups in 2025 is a critical question for founders looking to attract and retain top-tier talent in an increasingly competitive market. 

Startups often struggle to match the compensation packages offered by established corporations, making it harder to bring in the right people.

In this comprehensive guide, we’ll walk you through how to design an ESOP for startups in 2025, ensuring your plan is legally sound, appealing to employees, and scalable as your business grows.

Understanding ESOPs

What is an ESOP in a Startup?

An Employee Stock Option Plan (ESOP) is a strategic tool startups use to offer equity to team members without affecting short-term cash flow. Instead of offering high salaries, you grant employees the option to buy shares in your company at a set price in the future often determined using common startup valuation methods.

This isn’t instant ownership. Think of it as a commitment: employees earn the right to buy shares gradually over time, typically through a vesting schedule. This encourages long-term retention and aligns your team’s motivation with the company’s success.

For a founder, an ESOP is more than just compensation, it's a way to build a culture of ownership, reward early believers, and attract top talent even when budgets are lean.

Benefits of ESOPs for Startups

Designing an effective ESOP requires more than just offering shares. A well-thought-out policy includes specific terms that define how, when, and under what conditions employees can benefit. Here are the key components every founder should consider:

1. Helps Attract Great Talent

Skilled people want more than just a paycheck, they want to be part of something exciting. Offering equity makes your startup more appealing to those who want to grow with the company.

2. Keeps Employees for the Long Term

ESOPs usually come with a vesting schedule, meaning employees earn their shares over time. This gives them a reason to stay longer and be more committed to the company.

3. Saves Cash for the Business

Startups often can’t afford big salaries. With ESOPs, you can offer valuable rewards without spending extra cash, making it easier to manage your budget.

4. Aligns Everyone’s Goals

When employees own a part of the company, they care more about its success. Their goals match the company’s goals, which helps everyone work in the same direction.

5. Creates a Sense of Ownership

ESOPs make employees feel like they truly belong. When they know their efforts help increase the value of the company and their own shares, they’re more motivated and responsible.

Key Components of an ESOP Policy

Designing an effective ESOP requires more than just offering shares. A well-thought-out policy includes specific terms that define how, when, and under what conditions employees can benefit. Here are the key components every founder should consider:

1. Grant Size

The number of options offered to each employee, often based on role, seniority, and contribution.

2. Vesting Schedule

Defines how options are earned over time. A common structure is a 4-year vesting period with a 1-year cliff, meaning no shares vest until the employee completes one year, after which they vest gradually.

3. Exercise Price

The fixed price at which employees can purchase shares. This is usually set at the fair market value at the time of the grant.

4. Exercise Period

The time frame within which employees must exercise their options, often triggered by events like leaving the company or a liquidity event.

5. Exit Terms

What happens to unexercised or vested options when an employee resigns, is terminated, or if the company is acquired?

6. Pool Size

The total percentage of the company’s equity reserved for all ESOP grants. This typically ranges from 10–15% in early-stage startups.

Designing a Successful ESOP Policy

Designing an ESOP policy that works for both the company and its employees involves careful planning, legal understanding, and ongoing communication. 

Here’s a step-by-step guide to help you build a solid ESOP foundation for your startup:

Drafting an Effective ESOP Plan

a. Define Clear Objectives
Start by identifying the purpose of your ESOP. Are you trying to attract top talent, retain key team members, or prepare for a future IPO? Your goals will shape the policy structure.

b. Determine Eligibility Criteria
Decide who will be offered ESOPs, will it include all employees, only full-time staff, or senior leadership? Clear criteria promote fairness and transparency.

c. Decide on the Pool Size
Most startups allocate 10–15% of their total equity to the ESOP pool. Choose a size that supports current hiring needs and leaves room for future growth.

d. Set Vesting Schedules
The standard schedule is 4 years with a 1-year cliff. This means employees earn stock options gradually, starting after their first year, encouraging long-term commitment.

e. Determine the Exercise Price
This is the price at which employees can buy shares. It’s typically based on the company’s fair market value at the time of granting and should be updated through regular valuations.

Legal and Regulatory Considerations for Drafting an ESOP Policy

a. ESOP Rules for Private Companies in India
Private companies in India can issue ESOPs under Section 62(1)(b) of the Companies Act, 2013. Approvals from the board and shareholders are required. DPIIT-recognized startups may benefit from certain Startup India benefits and relaxations.

Benefits to DPIIT recognized startups related to ESOPs Tax Relief on ESOPs for Startup Employees From FY 2020-21, employees of DPIIT-recognized startups enjoy a tax deferral on ESOPs. Instead of paying tax when exercising options, TDS on the perquisite is postponed to the earliest of: 5 years from the year of allotment Sale of the shares Termination of employment When shares are eventually sold, capital gains tax applies on the difference between the sale price and the fair market value at the time of exercise.  ESOPs for Promoters and Directors in DPIIT-Recognized Startups Typically, companies can't issue ESOPs to promoters or directors holding over 10% equity.  However, DPIIT-recognized startups are exempt from this rule for 10 years from incorporation, allowing them to offer ESOPs to such individuals as part of their talent strategy as per Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014.

b. Drafting the ESOP Agreement
The ESOP agreement outlines all key terms, the number of options, the vesting schedule, the exercise price, and other important clauses. It should align with the shareholders’ agreement, and it’s crucial to involve legal professionals to ensure compliance.

c. Understanding ESOP Financing Options
Startups can structure their ESOPs using two primary methods:

• Non-Trust (Direct) Route: In this approach, employees receive shares directly. It includes:
   
  • Fresh Issue: The company issues new shares specifically for ESOPs, which leads to a slight dilution of existing equity.
  • Secondary Sale: Existing shareholders sell a portion of their shares to employees, allowing for liquidity without diluting ownership.
• Trust Route: A dedicated ESOP Trust is created to hold and manage shares on behalf of employees. The trust can acquire shares either through a fresh issue or by purchasing from existing shareholders.

While the Companies Act, 2013 (Section 62(1)(b)) governs the issuance of ESOPs, the trust mechanism is structured under the Indian Trusts Act, 1882. However, all share issuances, regardless of the route, must receive prior board and shareholder approval.

Each method impacts tax treatment and company ownership differently.

Implementing the ESOP

a. Communicate Clearly with Employees
Explain the ESOP policy in simple terms. Help employees understand how it works, what they stand to gain, and how their efforts contribute to company value.

b. Regularly Review and Update the Plan
As your company evolves, your ESOP should too. Revisit the plan periodically to ensure it aligns with changing business goals and market conditions.

Conclusion

Designing an ESOP for your startup in 2025 isn’t just a legal or financial exercise, it’s a strategic move that can shape your company’s culture and future.

Designing a thoughtful ESOP can turn team members into true stakeholders, fueling motivation, loyalty, and growth. The future starts with ownership.

Remember, your startup's biggest asset isn't your product: it's your people.

FAQs

Q. What is ESOP in a startup?

An ESOP (Employee Stock Option Plan) in a startup is a structured equity benefit that allows employees to purchase company shares at a predetermined price. 

It’s a key part of compensation that helps attract, retain, and motivate top talent by offering ownership in the business.

Q.How is ESOP financing structured?

ESOP financing can follow two routes:

• Non-Trust Route: Options are granted directly to employees through either a fresh issue of shares or secondary sales by existing shareholders.
   
• Trust Route: A trust is set up to acquire and manage ESOP shares on behalf of employees. While governed by the Indian Trusts Act, any issuance of shares must comply with Section 62(1)(b) of the Companies Act, 2013.

Q. Why should startups implement an ESOP policy?

Startups use ESOP policies to attract skilled talent without offering high salaries, improve employee retention through vesting, and align team incentives with company growth.

A well-designed ESOP plan is a strategic tool for long-term success.

Q. What are the benefits of ESOPs for startups?

Some major benefits of ESOPs in startups include:

• Attracting high-quality talent
• Reducing employee turnover
• Conserving cash flow
• Building a culture of ownership
• Aligning employee goals with business success

Q. Can DPIIT-recognized startups offer ESOPs to promoters or directors?

Yes, DPIIT-recognized startups can issue ESOPs to promoters and directors who hold over 10% equity; an exception not allowed for other private companies. This benefit is part of the regulatory flexibility offered under the Startup India initiative.

Q. How much equity should a startup allocate for its ESOP pool?

Typically, startups allocate 10–15% of their total equity to the ESOP pool, depending on the company’s size, growth stage, and hiring plans. This allocation ensures enough room to incentivize current and future employees.

Q. Are ESOPs taxable in India?

Yes. ESOPs are taxed twice:

• At exercise (as a perquisite, unless deferred for eligible startups)
• At sale (as capital gains, based on the difference between the selling price and the FMV on exercise)

Q. Do ESOPs dilute founder equity?

Yes. Issuing ESOPs from the equity pool reduces the ownership percentage of existing shareholders, including founders. However, the trade-off is better talent acquisition and retention.

Q. Can a startup revise its ESOP policy later?

Yes, ESOP policies should be reviewed and updated as the company scales. Changes may include adjusting pool size, vesting periods, or eligibility criteria.