India’s young innovators struggle as funding dries up and policies slow growth

Employee Stock Option Plans (Esops) are an important tool for start-ups. They give employees a chance to own a part of the company. This idea is often called “skin in the game”, because employees share both the risks and rewards of the company’s journey. When employees benefit from the company’s success, they work with more motivation and feel like equal partners in growth.

In many countries, Esops help start-ups attract talent without paying very high salaries. Employees accept lower salaries because they know their Esops may become valuable one day. When a company grows, lists on the stock market, or is sold for a high value, employees earn huge rewards from their Esops. This system creates a culture in which everyone wins together.

However, in India, Esops have become a “sob story” for both employees and founders. Even though India is the world’s third-largest start-up ecosystem, its rules and tax laws around Esops are outdated and difficult. Because of these restrictions, many Indian founders choose to make their company headquarters in the US or Singapore even though their entire business and team operate in India. This shows how unfriendly India’s Esop system is.

The fair market value problem and its heavy cost

The first major issue is what the law calls “fair market value” or FMV. Everywhere in the world, Esops are taxed in two parts: first as salary when employees exercise the Esop, and later as capital gains when they sell the shares. But the difference is that FMV in most countries is calculated reasonably. In India, however, FMV is treated in a way that harms employees.

Start-ups are valued based on their future potential, not on their current business. Investors also receive many special rights that ordinary employees do not get, such as anti-dilution protection or priority in case of company sale. Despite this, the price investors pay becomes the FMV for Esops. This means employees are taxed based on a valuation they cannot benefit from equally.

Boards and auditors are afraid to reduce FMV because they fear strict notices and long disputes with tax authorities. The result is painful: the more successful a start-up becomes, the higher the tax employees must pay when they exercise their Esops.

In listed companies, employees can buy their Esops and sell them immediately on the stock exchange to pay taxes. But in start-ups, there is no such market. Employees often take loans to pay Esop taxes and then wait years for an exit opportunity. If the start-up fails, employees end up in debt for shares that became worthless. This destroys the very purpose of “skin in the game”.

Another strange problem is that Esops are taxed at FMV, but the shares they convert into are valued at “book value”, which is much lower. So the right to buy something is taxed far more than the thing itself. This makes no sense and shows how India’s laws need urgent change.

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Promoters are banned from receiving Esops

The second major issue is even more surprising. Indian laws do not allow founders or promoters to receive Esops. This rule was created many decades ago when promoter-led companies were seen with suspicion. But today, most start-ups are founder-driven, with shareholders and investors playing an active role. In such modern structures, giving Esops to founders is normal across the world.

For example, Elon Musk’s famous Tesla compensation plan gave him extra shares based on company performance. It motivated him to grow Tesla enormously. In the US and other major countries, such performance-linked incentives for founders are permitted with shareholder approval. But in India, they are banned outright.

Because of this rule, the founder of Lenskart could not receive Esops legally. Instead, his incentive had to be created through a late secondary share purchase from existing shareholders. His share price was fixed much lower than the company’s IPO valuation. This created unnecessary controversy and harmed the brand image, even though it was done because the law offered no other option.

A system that needs urgent reform

In 2020, the Indian government tried to fix the problem but addressed only a small part. Tax payments for Esops were deferred for a very small group of start-ups registered with the Inter-Ministerial Board. Only companies less than ten years old, with revenue below ₹100 crore, and certified as “innovative” qualified. This left out thousands of fast-growing start-ups.

A comparison with the US, China, and Singapore shows how far behind India is:

• Founders can receive Esops in these countries if shareholders approve.

• FMV can be adjusted for illiquidity or special investor rights.

• In Singapore, FMV for Esops is the same as book value, which is fair and simple.

India’s refusal to adopt these practical ideas forces founders to move overseas, even if they want to build their companies in India. The tax collected from Esop exercises is small compared to the long-term value that start-ups generate for the country. India ends up losing more by being rigid.

What India must do now

The solution is simple and long overdue:

1. Allow founders to receive Esops, with approval from other shareholders.

2. Value Esops at book value, the same as regular equity shares.

Esops should motivate innovation, not create fear and debt. They should help founders and employees grow, not trap them in expensive tax burdens. India dreams of becoming a $10-trillion economy. For that to happen, its start-up policies must be modern, practical, and supportive.

Esops should be a symbol of partnership and trust. But today, India’s rules turn “skin in the game” into a painful burden. With simple reforms, India can unlock enormous entrepreneurial energy and ensure its start-up story is one of success, not struggle.