ESOPs Demystified : Taxes, Dilution & the Path to Wealth in IndiaESOPs Demystified : Taxes, Dilution & the Path to Wealth in India

After listening to Deepak, Vashistha, and Shray’s deep dive into ESOPs on their September podcast, I realised the content was incredibly valuable but difficult to digest in audio form alone. The sheer volume of numbers and scenarios required me to take detailed notes to truly grasp the mechanics.

To make this information more accessible, I’ve adapted their discussion into this article - complete with breakdown of the data points - to help you better navigate your own equity decisions.

-

For years, ESOPs in India were that thing you got on the side. You valued your salary, and the ESOPs were just... extra. A lottery ticket. Maybe they'd be worth something, maybe not.

Then came the Flipkart-Walmart deal in 2018.

Suddenly, employees who had valued that paper at zero were walking away with truckloads of money. Since then, with IPOs like Zomato, we’ve seen top management and early employees make hundreds of crores. The game changed. ESOPs are no longer a lottery ticket, they are a core instrument of compensation.

But here’s the problem. Most people don't understand the complex game they're playing.

The Real Trade-Off. 

When a founder at a one-year-old company is hiring, they're not really offering a package. They're making a pitch - "I can't afford to pay you market rate, so I'm giving up a piece of my own company. If we build this thing together, your piece will be worth far more than the cash I could have ever paid you."

Let's run the numbers.

Say an employer can’t pay you a 10 lakh salary. For you to take that risk, the ESOPs have to be worth a potential 50-60 lakhs in the future.

What's your alternative? You take that 10 lakh salary. After tax, you're left with maybe 6 lakhs. You invest that in the market for 10 years at a 14% CAGR. You're a good investor, so you 4x your money. You have approx 22 lakhs. Not bad.

Now, look at the ESOP bet. Let's say the company is valued at 5 crores. That 10 lakh salary you sacrificed gets you 2% of the company. The company grows, raises money, and you get diluted by 50%. You now own 1%. But the company hits it big. It’s now valued at 200 crores.

Your 1% stake is worth 2 crores.

You sacrificed 10 lakhs for a 2 crore payout. That’s a 20x return. This is the power of the ESOP. It’s a highly concentrated bet. For most employees, their ESOPs might be 90-95% of their net worth, a bet that could grow at 50-100% CAGR, something no public mutual fund can offer.

The Great Misunderstanding. ESOPs Are Not Shares

This is the single most important, and most painful, lesson. An ESOP is not a share. It is the option to buy a share at a predetermined strike price at a future date.

And this is where the taxman is waiting for you with a club.

When you convert your option (vested) into a share (exercised), you trigger a massive tax event. And it's not capital gains. It's taxed as a perquisite, as if it were a salary. It’s added to your income and taxed at your highest slab.

Let's walk through the trap:

1. The Grant: You are granted options with a strike price of 10.
2. The Vesting: Timeframe over which you earn full ownership of ESOPs granted.
3. Years pass. The company does well. The Fair Market Value (FMV) is now 100.
4. The Exercise: You decide to exercise your option. Meaning you decide to convert options into shares by paying the value at strike price.
5. The Tax: The Income Tax department looks at the difference (100 FMV - 10 Strike) = 90. This 90 is considered compensation.
6. The Bill: If you're in the highest tax bracket, you owe ~36 (40% of 90) to the government. Immediately.

To get one share worth 100, your total cash-out-of-pocket is 46 (10 to the company + 36 to the tax department). You have to pay this in cold, hard cash, to acquire an asset that is still unlisted and illiquid. You haven't made a single rupee, but you're already writing a massive cheque.

The Liquidity Gauntlet.

Okay, so you’ve paid the tax, you hold the shares. How do you actually get rich?

You're waiting for a liquidity event - an IPO or an acquisition. But even this is filled with traps. You might think, "My company was valued at $100M, and it sold for $120M. I'll get my cut of that 20% upside!"

Then you meet the VC's Liquidation Preference.

A VC might have invested 30M at that 100M valuation (owning 30%). Their terms might not say, "We get 30% of the exit." They might say, "We get our 30M back first, then we get 30% of the remaining 90M (27M)."

In this $120M sale, the VC doesn't take $36M. They take $57M ($30M + $27M), leaving far less on the table for you, the founders, and other employees.

Two Nightmare Scenarios

If the perquisite tax is a trap, these scenarios are a nightmare.

The Forced Exercise (When You Leave) You decide to leave the company. You look at your ESOP plan, and buried in the text is a clause: your vested options lapse and become worthless unless you exercise them within 90 days (or 6 months, if they're nice).

Now look back at our tax math. Your strike is 10. The FMV is 500. You must, right now, pay the 10 strike plus the perquisite tax on 490 per share. You're looking at a tax bill of lakhs, or even crores, that you have to pay in cash... or forfeit your entire stake. It’s a golden handcuff.

The Counterparty Risk (The Buyer Backs Out) You find a buyer in the pre-IPO market. Great. You agree on a price. But the process isn't instant.

1. You notify the company to exercise.
2. You pay the company the strike price + the perquisite tax.
3. The company takes ~2 weeks to allot the shares to your demat.
4. Then you transfer them to the buyer, who then pays you.

What happens if, in that two-week gap, the buyer backs out? The market changes, they lose funding, whatever. It doesn't matter. Your tax liability was already created the moment the shares were allotted. You are now on the hook for a massive tax bill, with no buyer and no cash.

This risk is so large that for employees with huge stakes (1-3% of a company), it might make sense to exercise and pay the tax earlier when the valuation is lower, rather than wait until their stake is worth 200 crores and the tax bill is an impossible 80-90 crores.

The Stock-for-Stock Shuffle

Often, in an acquisition, you don't even get cash. You get stock in the acquiring company.

The acquirer says, "Your 100 ESOPs are worth 6,000, so we'll give you 6,000 worth of our unlisted stock."

The taxman arrives: "Great. You received 6,000 of value. Pay me a perquisite tax on that."

You say "With what money?! You just gave me more stock!"

There is a common solution used in industry for this. The acquirer gives you 4,000 in stock and 2,000 in cash - just enough cash to pay the tax on the total 6,000. In this deal, the VCs get all their cash, and you, the employee, are not rich. You've just swapped one illiquid holding for another.

Your ESOP Survival Guide

So, what should you actually check in that grant letter? It's not just the number of options.

1. Vesting Period & Cliff: How long until you own them? (A 1-year cliff is standard).
2. Strike Price vs. FMV: Are you getting them "at the money" (Strike = FMV) or "in the money" (Strike < FMV)?
3. The Single Most Important Clause: What is the expiry period after you leave? Is it 90 days? 6 months? This one clause determines whether you have a valuable asset or a tax-trap.

And one more thing. You can't just sell your shares to anyone. It's a private company, the board must approve the transfer.

Don't go against the promoters. You will not win this fight. We all saw the stories from Reliance Retail. Employees sold their shares in the private market at high valuations. Reliance, the parent, didn't like it. They simply created a new holding company (Reliance Retail Ventures Ltd) above the old one. All new acquisitions and value-creation flowed into the new company. The old company, where employees held shares, stagnated. Eventually, they had to sell at the promoter's lower price.

You Won. The Bet Paid Off. Now What?

Let's say you did it. You navigated the cliffs, the VCs, the perquisite taxes, and the promoters. You have a windfall.

Your first instinct is to find the next 400% CAGR bet. Don't.

The riskiest bet of your life has paid off. You won. The game is over. Your job now is capital preservation. Your new expectation for returns is not 400%; it's 15-16% in a boring, diversified basket of public mutual funds. Any wealth manager who promises to beat your ESOP return is lying.

For people in the founding space, there's a good chance they'll make a lot more money... but only by starting a new company, if that's what their real ambition is.

And then? Do the one thing this whole journey was for.

Spend the money.

You've met your financial goals. The rest is yours. As Deepak puts it, "Money is just a number. You don't have to be worth 50 crores all your life. You can be worth zero when you die... In order to get from 50 down to zero, you're going to have to spend that money."

So, this is the time to go and enjoy your life. Do the things you were afraid to do. Spend it. Even charity is a form of spending - it's money that's not coming back. And of course, you can pay it back to the community by investing in other fledgling startups, helping them start their own journey.