Key Takeaways
- Two separate valuations are involved, and they exist for different purposes at different dates.
- Fair market value of unlisted shares on the exercise date must come from a merchant banker.
- The accounting charge runs through the profit and loss account over the vesting period, whether or not options are exercised.
- Perquisite tax arises at exercise and is a payroll obligation for the company, not a problem for the employee alone.
- Recognised startups may defer the tax deduction at source, which changes how a scheme is communicated.
Executive Summary
An ESOP valuation question turned what the founders had treated as a retention gesture into a structured exercise with accounting, tax and payroll consequences. The company had promised equity to eleven employees over three years. Nothing had been documented and no valuation had ever been obtained.
JPKAD & Associates was engaged after the company completed an institutional round and its investor asked how the promised equity would be honoured.
Work covered scheme design, the accounting charge under the applicable share based payment framework, the tax position at grant, vesting, exercise and sale, and the cap table effect of the pool.
The point that reshaped the design was that two different valuations are required, for different purposes, at different dates, and that one of them cannot be provided by the company’s own accountants.
The scheme was adopted, historical promises were brought inside it, and employees received a written explanation of what they would owe and when. The corporate secretarial filings and the scheme drafting were handled by the company’s own advisers.
Promised equity to staff without documenting it? Explore our advisory work at https://jpkad.com/contact-us/
Client Overview
The client is a technology company in Kochi selling a subscription product to business customers in India and the Gulf. It employs a small engineering and customer team and had recently closed its first institutional round.
The founders had promised equity informally to early employees, in conversations and in one case in an offer letter, without any scheme in place.
Those promises were made in good faith and in terms nobody could later reconstruct precisely. Two employees believed they held a fixed number of shares and two believed they held a percentage.
The company had been recognised as a startup under the relevant government scheme, which turned out to matter for two separate reasons.
Finance was a single accountant with external support for statutory audit and tax. Payroll was run in house on a spreadsheet driven process.
Business Challenges
The company had made promises it intended to keep and had created obligations it had not recognised. Neither problem was visible until an investor asked a direct question.
Four issues had to be resolved before any scheme could be adopted.
Why could the informal promises not simply be honoured?
Because they were inconsistent with one another. Two employees understood they held a fixed number of shares and two understood they held a percentage of the company.
A percentage promise made before an institutional round means something very different after it, and neither party had considered that when the words were used.
One promise sat in an offer letter and the rest existed in conversations, so the documentary position varied between employees who believed they were on equal terms.
Honouring the promises required first establishing what each person actually believed, which took individual conversations rather than a reading of the files.
Why are two separate valuations involved?
Because accounting and tax ask different questions at different dates and the answers are not interchangeable.
For accounting, a fair value at the date of grant drives the charge recognised over the vesting period under the applicable share based payment framework.
For tax, fair market value at the date of exercise determines the perquisite in the employee’s hands, which is a different date and often a very different figure.
The founders had assumed a single valuation obtained once would serve every purpose, which is the most common misunderstanding in this area.
Why can the company’s own accountants not provide the exercise date value?
Because the rules specify who may determine fair market value of unlisted shares for this purpose, and that is a merchant banker.
This is not a matter of competence. It is a question of who the rules permit, and the answer differs by purpose across the various valuation requirements in Indian law.
Valuation requirements elsewhere, including under the company law and under other provisions of the tax law, name different categories of valuer.
Establishing early which valuer is needed for which purpose avoids obtaining a certificate that cannot be used for the purpose it was obtained for.
What had nobody accounted for?
The charge to the profit and loss account. Options are compensation, and the fair value at grant is recognised over the vesting period whether or not anyone ever exercises.
That charge does not involve cash, which is why founders are frequently surprised by it, and it affects the reported result the investor will read.
The payroll obligation at exercise was the second surprise. Perquisite tax is deducted by the company, so an employee exercising creates a cash tax obligation for the employer to discharge.
Neither point changes whether a scheme is worth having. Both change how it should be sized, timed and explained.
Assuming one valuation covers every purpose? Read more about our taxation work at https://jpkad.com/service/taxation/
Business Objectives
The founders wanted to honour what they had promised, to give the investor a defensible answer, and to avoid creating an obligation the company could not fund.
What did the company need to achieve?
A scheme that could absorb the historical promises without leaving anyone worse off than they believed they were.
A pool size that made sense against the cap table after the round rather than against the company as it had been when promises were made.
Clarity on the accounting charge before adoption, since the investor would see its effect in the reported result.
And a communication that told employees plainly what they would owe and when, because a benefit that produces an unexpected tax bill damages trust rather than building it.
Why was the tax point treated as a design constraint?
Because perquisite tax arises at exercise, on a value the employee has not received in cash, and a shareholding in an unlisted company cannot easily be sold to fund it.
That mismatch is the single most common reason employee equity generates resentment rather than retention.
Recognition as an eligible startup opened a deferral of the deduction at source, which changes the position materially for those who qualify.
Design decisions on exercise windows and on the exercise price were therefore taken with the employee cash position in mind rather than only the company’s.
What defined success for this engagement?
A scheme adopted with proper approvals, absorbing every historical promise, with each employee holding a written grant document.
The accounting treatment settled and agreed with the statutory auditor before adoption rather than debated at year end.
Valuation responsibilities allocated correctly, with the right category of valuer identified for each purpose and date.
And employees able to explain, in their own words, what they hold and what happens when they exercise it.
Success also required the register of options to exist from the day of adoption, because every future exercise and due diligence depends on it.
Want a scheme employees actually understand? Explore our approach at https://jpkad.com/contact-us/
Solution Strategy
Design followed the consequences rather than the intention. The pool was sized last, after the accounting charge, the tax profile and the cap table effect had all been modelled.
Scheme drafting and the corporate secretarial filings stayed with the company’s own advisers. The financial, accounting and tax analysis sat alongside them.
How were the historical promises reconciled?
Through individual conversations with each of the eleven employees, recording what each understood they had been promised and on what basis.
Those accounts were compared against offer letters, emails and the founders’ own recollection, and the differences were written down rather than smoothed over.
Where an employee had understood a percentage, the effect of the institutional round was explained before any conversion was proposed.
Each person then received a written statement of what would be granted under the scheme and how it related to what had been discussed originally.
How was the accounting charge modelled?
By establishing a fair value at grant under the applicable share based payment framework and recognising it across the vesting period.
Expected forfeiture was estimated and applied, since not every option granted will vest, and the estimate is revisited each period.
The charge was modelled across three years so the founders could see its effect on reported results before the scheme was adopted.
The statutory auditor was consulted on the approach at that stage rather than presented with a completed scheme at year end.
How was the tax profile mapped?
Stage by stage. No tax at grant. No tax at vesting. Perquisite at exercise on the difference between fair market value on that date and the exercise price.
Capital gains at sale, with the value used for the perquisite becoming the cost of acquisition, so the employee is not taxed twice on the same amount.
The deferral available to recognised eligible startups was assessed against the company’s position and the conditions attached to it.
The payroll mechanics were then designed, since the obligation to deduct sits with the company and has to be funded when an employee exercises.
How was the pool sized and the exercise price set?
Against the cap table after the institutional round, on a fully diluted basis, including the pool created as part of that round.
Sizing considered the historical promises, expected hiring over two years and the dilution the founders were prepared to accept.
The exercise price was set with the employee cash position in mind, because a high exercise price and a perquisite at exercise together create a barrier.
The company is free to determine the exercise price subject to the accounting consequences, and those consequences were modelled before the price was fixed.
How were non resident employees handled?
Two employees were resident outside India, which brings exchange control requirements alongside the company law and tax position.
Grants to persons resident outside India are permitted subject to conditions, and a separate report is required within the prescribed period.
That reporting was aligned with the company’s other exchange control filings so it would not become a second forgotten obligation.
Their personal tax position in their country of residence was flagged as a matter for their own advisers rather than addressed here.
Need the accounting charge modelled before you adopt a scheme? Read more at https://jpkad.com/service/accounting-and-financial-reporting/
Valuations and Records Used
The work rested on getting the right valuation from the right person at the right date, and on record keeping that would survive an exercise several years later.
Which ESOP valuation was needed at each stage and from whom?
A fair value at the date of grant for accounting purposes, established on a basis agreed with the statutory auditor and documented with its workings.
Fair market value on the exercise date will be obtained from a merchant banker, as the rules require for unlisted shares, at each exercise event.
The company was told plainly that this second valuation cannot be produced by its own accountants, and the reason why.
Both requirements were written into the scheme administration checklist so that a future exercise does not stall while a valuer is appointed.
What records does the scheme require?
A register of options showing grant date, number, exercise price, vesting schedule and status for each employee.
Individual grant letters and acceptances, since a grant that cannot be evidenced is difficult to honour and difficult to account for.
Board and shareholder approvals with the prescribed disclosures, held with the scheme document itself.
Forfeiture and lapse records, because the accounting estimate is revisited each period and the register is the source for it.
All of it sits in one place with a named owner, since a scheme administered across personal folders becomes unreliable within two years.
How was payroll prepared for exercise events?
By building the perquisite calculation into the payroll process in advance rather than treating each exercise as an exception.
The deduction obligation sits with the company, so an exercise creates a cash requirement that has to be planned rather than discovered.
Where the deferral for recognised eligible startups applies, the conditions and the tracking requirements were documented for the payroll owner.
Employees were given a written illustration of the calculation so that the number appearing on a payslip would not be a surprise.
Implementation Process
The engagement ran across about nine weeks. Reconciling the historical promises took longer than every technical question combined, because it involved eleven separate conversations.
The founders were advised to hold those conversations themselves, with support, rather than delegating them.
How were the employee conversations handled?
Individually and in person, with a written note of what each employee understood, confirmed back to them afterwards.
The founders led each conversation. A promise made personally is difficult to renegotiate through an adviser without damaging the relationship it was meant to build.
Where a percentage had been promised before the round, the arithmetic was explained rather than asserted, and the employee was given time to consider it.
Every employee accepted the position eventually. Two took a fortnight, which the founders had not expected and which was reasonable.
How was the accounting approach agreed?
By taking the proposed fair value basis and the forfeiture estimate to the statutory auditor before the scheme was adopted.
Agreeing the treatment in advance avoids the situation where a scheme is in place and the charge is disputed at year end.
The three year model of the charge was shared with the founders and with the investor’s nominee on the board.
That transparency mattered, because a non cash charge appearing without warning in a reported result invites questions that are awkward to answer late.
How was the scheme adopted?
Through the approvals the Companies Act requires, with the prescribed disclosures in the explanatory statement, handled by the company’s own advisers.
Grant letters were issued individually, with a vesting schedule respecting the minimum vesting period the rules require.
Eligibility was checked against the categories the rules exclude, taking account of the relaxation available to recognised startups.
The register of options was opened at adoption rather than created later from grant letters, which is how registers end up incomplete.
Grant dates were staggered slightly across the cohort so that vesting and any future exercise would not all fall in a single payroll month.
How were employees informed?
Through a short written explanation covering what an option is, when it vests, what exercise costs and what tax arises at that point.
A worked illustration accompanied it, using round numbers, showing the perquisite calculation and the later capital gains position.
The deferral available to recognised eligible startups was explained plainly, including its conditions rather than only its benefit.
A single named person inside the company owns scheme administration, so employees have somewhere to ask rather than approaching different founders.
Have employees who believe they own something undocumented? Explore how we can help at https://jpkad.com/contact-us/
Business Results
Results are described here in direction of change rather than in figures. Tax and accounting outcomes depend on the facts and on valuations obtained at the relevant dates, and figures would imply a certainty that does not exist.
What follows is what the company reported after the scheme was adopted.
What changed about the historical promises?
Every promise now sits inside the scheme, evidenced by a grant letter and recorded in the register of options.
The inconsistency between fixed number and percentage understandings was resolved individually rather than by a blanket rule imposed on everyone.
Employees who had believed they held a percentage understand how the institutional round affected that, which they did not before.
Nothing was withdrawn. What changed is that what was promised can now be evidenced and honoured.
The founders also stopped making equity commitments in conversation, which is the practice that created the reconciliation exercise in the first place.
What changed about the company’s reporting?
The share based payment charge is recognised on a basis agreed with the statutory auditor before adoption rather than negotiated at year end.
The board and the investor nominee saw the modelled effect on reported results before the scheme was approved.
Forfeiture estimates are revisited each period against the register, so the charge reflects what is actually expected to vest.
The reported result now carries a charge that was previously invisible, which is a truer picture rather than a worse one.
What changed for employees?
They hold a document rather than a recollection, with a vesting schedule and an exercise price stated in writing.
They know a tax charge arises at exercise, on a value they have not received in cash, and they know why.
Those eligible understand the deferral available to recognised eligible startups, including the conditions attached to it.
Questions now go to a named administrator rather than to whichever founder is available, which has reduced the informal promising that started the problem.
What changed structurally?
The register of options is maintained from adoption, which is the record every future exercise, audit and due diligence will depend on.
Valuation responsibilities are allocated in writing, with the merchant banker requirement at exercise recorded so it is not discovered at the last moment.
Payroll can compute a perquisite deduction as a routine step rather than as an exception requiring outside help.
Exchange control reporting for the two employees resident outside India sits on the same calendar as the company’s other filings.
Want the valuation responsibilities settled before the first exercise? Explore our advisory work at https://jpkad.com/contact-us/
Lessons Learned
The technical questions here have settled answers. What took the time was that promises had been made in conversation, and conversations do not reconcile to a register.
What surprised the founders most?
That two valuations are needed, for different purposes at different dates, and that one of them cannot come from their own accountants.
That the accounting charge runs whether or not anyone exercises, and that it would appear in the result the investor reads.
That perquisite tax at exercise is deducted by the company, which turns an employee’s decision into an employer cash obligation.
Four employees turned out to hold four different understandings of what they had been promised, all in good faith.
What worked better than expected?
The founders holding the employee conversations themselves. Delegating them to an adviser would have damaged the goodwill the promises were meant to create.
Taking the accounting approach to the statutory auditor before adoption rather than after it.
Providing employees with a worked illustration rather than a policy document. People understood the tax point from the arithmetic, not from the explanation.
Sizing the pool last. Every earlier attempt to fix a number first ran into a consequence that had not yet been modelled.
What would be done differently next time?
A scheme would be adopted before any equity is promised, so that promises are grants rather than recollections.
The valuation responsibilities would be documented at adoption rather than established when the first exercise approaches.
The register of options would be opened on day one, since a register reconstructed later is never quite complete.
Employee communication would happen at grant rather than after adoption, when the tax point is still abstract and easier to absorb.
The exchange control reporting for employees resident outside India would be diarised at grant, rather than being identified during scheme design.
What should other founders check first?
Establish whether anything has been promised that is not documented, and ask each person what they believe they hold.
Confirm whether the accounting charge for any existing scheme has been recognised, because it applies whether or not options are exercised.
Identify who will provide the exercise date valuation, since the rules specify a merchant banker for unlisted shares.
Consider whether the company qualifies for the startup deferral, because it changes what can honestly be told to employees.
Look also at whether anyone has left the company believing they held something, because unresolved promises follow former employees out of the door.
Frequently Asked Questions
What is an ESOP valuation and why are two needed?
Accounting requires a fair value at the date of grant, which drives the charge recognised over the vesting period. Tax requires fair market value on the date of exercise, which determines the perquisite in the employee’s hands. Different purposes, different dates and often very different figures. A single valuation obtained once does not serve both.
Who can determine fair market value of unlisted shares for ESOP tax purposes?
The rules specify a merchant banker for unlisted shares for this purpose. The company’s own accountants cannot provide it, and this is a question of who the rules permit rather than of competence. Valuation requirements elsewhere in company law and tax law name different categories of valuer, so identifying the correct one early avoids obtaining an unusable certificate.
When does an employee pay tax on stock options in India?
Twice, at different stages. A perquisite arises at exercise, being the difference between fair market value on the exercise date and the exercise price, taxed as salary with the company deducting tax at source. Capital gains arise later on sale, with the value used for the perquisite becoming the cost of acquisition, so the same amount is not taxed twice.
Can the tax at exercise be deferred?
A deferral of the deduction at source is available to employees of eligible startups recognised under the relevant provisions, subject to conditions and to a defined outer point at which the tax becomes payable. It is not available generally. Where it applies it materially changes the employee cash position, and its conditions should be explained alongside its benefit.
Does the company incur a cost even if nobody exercises?
Yes. Options are compensation, and the fair value established at grant is recognised in the profit and loss account over the vesting period, adjusted for expected forfeitures. The charge does not involve cash, which is why founders are often surprised by it, but it affects the reported result that investors and lenders read.
What approvals does an ESOP scheme need?
Shareholder approval by special resolution under the Companies Act read with the applicable rules, with prescribed disclosures in the explanatory statement. Separate approvals are required in specified situations, including grants to employees of a holding or subsidiary company. A minimum vesting period of one year from grant applies. Corporate secretarial filings follow adoption.
Can promoters and large shareholder directors receive options?
Generally the rules exclude promoters, members of the promoter group and directors holding more than a specified proportion of equity. A relaxation is available to startups recognised under the relevant scheme for a defined period from incorporation. Eligibility should be checked against the current rules before grants are made rather than after.
What happens to equity promised informally before a scheme exists?
It has to be reconciled and brought inside the scheme, which usually means individual conversations rather than a reading of the files. Employees frequently hold inconsistent understandings, some in fixed numbers and some in percentages, all held in good faith. A percentage promised before a funding round means something different after it, and that needs explaining rather than asserting.
Are there exchange control requirements for employees outside India?
Grants to persons resident outside India are permitted subject to conditions, and a separate report is required within the prescribed period. It is worth aligning that reporting with the company’s other exchange control filings, because an isolated obligation attached to a single event is exactly the kind that gets missed.
How long does it take to put a scheme in place?
This engagement ran about nine weeks, and reconciling eleven informal promises took longer than every technical question combined. Where no promises exist to unwind, scheme design, accounting agreement with the auditor and adoption can move considerably faster. The employee communication should not be compressed, since that is what determines whether the scheme achieves anything.
Conclusion
An ESOP valuation is not one number obtained once. It is a fair value at grant that drives an accounting charge the company will carry whether or not anyone exercises, and a fair market value at exercise that determines a perquisite the company must deduct tax on. Different purposes, different dates, and for unlisted shares the second must come from a merchant banker rather than from the company’s own accountants. Those facts reshaped a scheme the founders had thought of as a retention gesture. What took the time was not any of it. Eleven employees had been promised equity in conversation, four of them held four different understandings of what that meant, and every one of those understandings had been formed in good faith. Reconciling them required the founders to hold eleven individual conversations themselves, which is slower than delegating and is the only approach that preserves the goodwill the promises were meant to create. If your company has promised equity that is not documented, the first step is not a valuation. It is asking each person what they believe they hold. JPKAD & Associates advises companies on employee equity design, accounting and tax alongside their corporate secretarial advisers, and you can read more through the contact page at https://jpkad.com/contact-us/