Employee Stock Option Plans (ESOPs) have emerged as a strategic tool for Indian startups and private limited companies to attract and retain top talent. While ESOPs enhance employee motivation and align long-term goals, their implementation has a direct and significant impact on a company’s financial statements, taxation, and shareholding structure.
In this article, we delve deep into how ESOPs affect financials and equity dilution, helping startup founders, CFOs, HR professionals, and investors make informed decisions.
What is an ESOP?
An Employee Stock Option Plan (ESOP) allows employees to purchase company shares at a predetermined exercise price, often lower than the fair market value (FMV). These shares vest over time, enabling employees to become shareholders, thus driving loyalty and ownership.
Financial Impact of ESOPs on Indian Companies
1. Expense Recognition (Ind AS 102 & GAAP)
Under Indian Accounting Standards (Ind AS 102: Share-Based Payment), companies must account for the fair value of ESOPs as an expense in the Profit & Loss Statement, even if there’s no cash outflow.
- This affects the EBITDA and net profit.
- Expense is spread over the vesting period using valuation models like Black-Scholes.
Example: For 1,000 ESOPs with ₹100 fair value and a 4-year vesting period, ₹25,000 will be expensed annually.
2. Earnings Per Share (EPS) Dilution
Once options are exercised:
- Basic EPS is based on existing shares.
- Diluted EPS considers potential ESOP conversions, reducing per-share earnings.
3. Deferred Tax Asset (DTA)
ESOP-related expenses can generate Deferred Tax Assets due to timing differences between book and tax accounting, providing some relief to net income.
Impact on Shareholding & Cap Table
1. Equity Dilution
When ESOPs are exercised, new shares are issued, increasing the paid-up capital and reducing existing shareholders’ percentage holdings.
Example: If a company has 10 lakh shares and issues 1 lakh ESOPs, shareholding dilutes post-allotment to 11 lakh shares.
2. Cap Table Restructuring
- Founders and early investors may experience ownership dilution.
- VCs and Angels typically request a 10–15% ESOP pool before funding.
3. Pre- vs Post-Funding Dilution
Investors prefer ESOP pools to be created pre-funding so that promoters bear the dilution, not new investors.
4. Control Shift
In rare cases, heavy ESOP exercise may shift voting power—important to watch during mergers or acquisitions.
Valuation, Pool Creation & Compliance
- 409A Valuation / FMV Certificate is essential before granting ESOPs.
- Creating an ESOP pool doesn’t cause dilution immediately; dilution happens when options are exercised.
- Legal filings like MGT-14, PAS-3, and maintaining SH-6 register are mandatory.
- DPIIT-recognized startups enjoy deferred tax benefits on ESOPs.
Taxation on ESOPs in India
- On exercise, employees pay perquisite tax on the difference between FMV and exercise price.
- On sale, capital gains tax is applicable based on the holding period.
Conclusion
While ESOPs are a non-cash incentive, they impact profit margins, EPS, and shareholding control. Therefore, strategic planning is crucial. Companies must align ESOP structuring with long-term goals and ensure full legal and financial compliance.
At Lal Ghai & Associates, we provide end-to-end ESOP consulting services including policy drafting, accounting, compliance, taxation, and cap table management.