Regulating Founder ESOPs: SEBI's new proposal and its implications

The author is Anany Tiwari, a 4th Year student at Hidayatullah National Law University, Raipur.

Introduction

Recently, the Securities and Exchange Board of India (SEBI) has proposed an amendment, through a consultation paper dated March 20, 2025, to the SEBI (Share Based Employee Benefits and Sweat Equity) Regulations, 2021 (SEBI SBEB & SE Regulations). The primary objective is to fill the existing gap regarding streamlining the treatment of Employee Stock Options (ESOPs) granted to the founders of New-Age Technology Companies (NATCs), who are classified as promoters when the company pursues an Initial Public Offering (IPO). Once a founder is classified as a promoter, he no longer remains an employee under the existing laws. Hence, the question arises, what would happen to the ESOPs that were granted to them? This amendment proposes to validate ESOPs post-filing of a Draft Red Herring Prospectus (DRHP) for an IPO. 

This article first examines the present framework regarding the grant of ESOPs to the founders and the challenges faced by them when they are tagged as promoters at the stage of IPO. Secondly, key aspects of the proposed amendment are looked into and how it addresses the challenge that founders face at the stage of IPO. Thirdly, it analyses the shortcomings in the proposed amendment and its impact.  Lastly, a comparative assessment of the approach that is followed by other countries in granting ESOPs to their promoters is compared with the Indian approach. 

Background and Existing Legal Landscape 

Under the current framework, companies cannot grant ESOPs to promoters. This Limitation arises from Rule 12 of the Companies (Issue of share capital and Debenture) Rules, 2014 read with Regulation 2(1)(i) of SEBI SBEB & SE. However, an exception exists for startups registered with the Department for Promotion of Industry and Internal Trade (DPIIT). This stems from the recommendations made in the Companies Law Committee Report, 2016, which recognized that promoters in startups often function as employees or whole-time directors. The exemption allows such founders to be compensated with ESOPs without affecting cash flows.

ESOPs are granted to the founder in the initial years of the company to avoid dilution from the successive rounds of investment and to avoid cash compensation. The Companies Act, 2013, under section 62(1)(b) and Rule 12 of the Companies (Issue of Share Capital and Debenture) Rules, 2014, do not consider the promoters to be employees. Further, Issue of Capital and Disclosure Requirements (ICDR) regulations, promoters are defined as those who exercise control over the issuer, meaning founders are reclassified as promoters when the company files its DRHP.

Therefore, it is unclear whether the ESOPs that were granted to the founder pre-filing of DHRP would remain valid post-filing of DHRP. This ambiguity creates uncertainty for founders who rely on ESOPs as long-term incentives.

Proposed Amendment 

To address the challenge of the founders at the stage of filing for DHRP, SEBI has proposed an amendment to allow the employees who are later recognized as promoters to retain the ESOPs that they had before filing for DHRP. The key condition is that the ESOPs must have been granted a year before the Board decided to move for an IPO. The amendment specifies that if ESOPs are granted to the founders a year or more before the company decides to go for an IPO, they can continue to hold the same in the capacity of a promoter post-IPO. By allowing pre-IPO ESOPs to be retained post-IPO, and enforcing a one-year holding period, SEBI aims to protect long-term incentives without encouraging opportunistic behaviour.

Analysis 

It is essential to mention that when an individual ceases to be an employee, Regulation 9(6) of the SEBI SBEB & SE Regulations 2021 comes into the picture. The proviso to this regulation clearly states that such employees are entitled to the vested ESOPs. Further, in case of retirement or superannuation, ESOPs that were granted but not vested will continue to vest. Along these lines, SEBI proposed this amendment, where an employee is classified as a promoter and has proposed that such a classification should not let them forego their benefit, which formed part of their remuneration. Therefore, a second explanation is proposed to be added to Regulation 9(6), clarifying that the employees who were granted ESOPs before being identified as promoters would be eligible for holding such ESOPs. 

The amendment seeks to strike a crucial balance between preventing regulatory arbitrage and recognizing genuine employee contributions. The one-year holding requirement ensures that ESOPs are not misused as a last-minute incentive just before a public offering while still protecting long-term contributions. 

While the proposed amendment provides much-needed clarity, it does not fully resolve the regulatory challenges surrounding founder ESOPs. First, while the existing ESOPs are carried forward despite becoming promoters, no provisions have been proposed to issue new ESOPs post IPOs. This may lead to deterrence in companies offering long-term incentives to the promoters and can also lead to the dilution of their shares with each successive issue. Therefore, reconsidering allowing fresh grants would enhance the founder's protection. Secondly, there’s ambiguity in defining the one-year look-back period as the proposal does not clarify whether the one year is calculated from the board's initial decision of going public or formal approval or the actual DHRP filing. Given that the timelines for an IPO can be unpredictable, defining this period from the DHRP filing date may provide greater clarity. Lastly, by allowing ESOPs to be granted post-issue and clarifying the date of a one-year look back, the amendment could encourage more NATCs to go public. However, the inability to issue fresh ESOPs post-IPO may discourage some founders from seeking promoter designation, potentially leading to structuring loopholes.

Additionally, this consultation paper has come amid reports that SEBI is considering implementing stricter disclosure norms for the IPO-bound NATCs. One of the major proposed changes is to extend the disclosure timeline for past transactions and fundraising from 18 months to 3 years. This implies that all the transactions for the past three years have to be disclosed. This would ensure that no last-minute ESOP grant or equity restructuring could benefit founders or insiders before the IPO. SEBI is both easing certain ESOP restrictions (to encourage listing) and tightening financial disclosure rules (to improve transparency).

International Scenario

In the United States, there is no express bar for promoters to grant ESOPs. However, highly compensated employees (HCEs) are barred from being granted ESPOs. HCEs are employees who hold more than 5 per cent of the company or have been salaried above USD 80,000. 

Germans have Employee Share Options, which are akin to ESOPs, with no specific restriction on employee eligibility for exercising these options. However, Members of the supervisory board are not granted such share options. 

In Singapore, restrictions on granting ESOPs only apply to public companies. If an individual holds 15 per cent or more of the voting rights, shareholder approval is required before ESOPs can be granted.  Additionally, if granting ESOPs would raise an employee’s total holdings to 5% of the available options, shareholder consent is also necessary.

When we compare the approach adopted internationally, the Indian approach appears to be restrictive for granting ESOPs to the promoters. The approach adopted by the US and Germany seems to be less stringent when compared to the one adopted by India, wherein there is complete exclusion of promoters as they do not fall under the definition of employee. The proposed amendment is a welcome step, since the present rules effectively penalise the founders who have contributed significantly to the company’s early growth. Founders may have ceased to be employees in a formal sense, yet they play an essential role in the strategic direction of the firm. Denying ESOPs that were granted to them during their tenure has long been viewed to be arbitrary. Moreover, the Singapore model, which requires shareholder approval for significant ESOP allocations, offers a potential middle ground that India could consider to balance founder incentives with investor protection.

Conclusion

The proposed amendment is a welcome step, addressing the challenge that founders faced post-IPO in regards to their ESOPs. By allowing a one-year look-back period, SEBI acknowledges the significant contribution of founders at the forming stages of the company and at the same time ensures that last-minute allotment doesn’t create any regulatory arbitrage. However, the amendment does not propose a provision for the issue of ESOPs to promoters post-IPO, which could deter long-term incentives for founders.