The Securities and Exchange Board of India (Sebi) is evaluating a significant policy change that could reshape the landscape for startup founders preparing for initial public offerings (IPOs). A consultation paper released on Thursday suggests that Sebi may allow startup founders, categorized as promoters or part of the promoter group, to retain or exercise Employee Stock Ownership Plans (ESOPs) granted up to one year before an IPO.
Currently, ESOPs are reserved for employees, and existing regulations prohibit their issuance to promoters. However, startup founders often receive ESOPs or equity-linked incentives instead of direct cash compensation during the company’s early years. Sebi’s proposal aims to provide regulatory clarity while preventing any potential misuse of stock options.
Existing Regulations and Need for Change
Under the Companies (Share Capital and Debentures) Rules, 2014, ESOPs cannot be issued to promoters. This rule intends to ensure that ESOPs serve as an incentive mechanism for employees rather than a tool for promoters to increase their control over the company. However, as startups grow and prepare for public listings, founders frequently transition from being classified as employees to promoters due to increased equity holdings.
The current regulations do not clearly address whether employees who become promoters before an IPO can still exercise their ESOPs. To resolve this ambiguity, Sebi has proposed modifications to existing guidelines. According to the consultation paper, ESOPs should remain valid for founders even if they are reclassified as promoters, ensuring policy certainty and avoiding unjust forfeiture of benefits.
Rationale Behind Sebi’s Proposal
Sebi acknowledges the critical role that ESOPs play in aligning founders’ incentives with company performance. In its consultation paper, the regulator stated, “The classification of a founder as a promoter arises from the practice of considering shareholding, including options that are either vested or granted. These options and other benefits are part of the employee’s remuneration. Thus, the view that an employee who is later categorised as a promoter due to their shareholding, including options and benefits, would have to forgo these benefits may not be justifiable.”
Since startup founders often accept lower salaries in favor of stock-based compensation, losing ESOP benefits solely due to reclassification as promoters would undermine their financial rewards. Vishal Yaduvanshi, Partner and Regional Co-Head of Capital Markets (North) at Cyril Amarchand Mangaldas, highlighted this point, stating, “ESOPs form a great incentive tool. By allowing such founders to continue holding ESOPs even post reclassification as promoters, the policy ensures alignment of interests and certainty in outcomes.”
Safeguards to Prevent Misuse
While Sebi is open to granting this relaxation, the regulator also recognizes the potential risks of stock manipulation or preferential treatment. To mitigate these risks, Sebi has proposed a cooling-off period before an IPO. This restriction would prevent last-minute ESOP grants that could artificially inflate ownership stakes or create conflicts of interest.
By imposing a one-year minimum period before an IPO for ESOP eligibility, Sebi aims to maintain market integrity and protect retail investors. This measure ensures that ESOP allocations are based on long-term performance rather than opportunistic moves ahead of public listings.
Clarifications on Shareholding Norms
Sebi’s consultation paper also addresses another crucial aspect of IPO preparations—clarifying the minimum holding period for equity shares eligible for an offer for sale (OFS) in public issues. The proposal includes equity shares obtained through the conversion of fully paid-up compulsorily convertible securities under the one-year minimum holding requirement.
This change aims to eliminate confusion and create a level playing field for different types of equity holdings. By ensuring that all such converted shares adhere to the same minimum holding period, Sebi enhances transparency and regulatory consistency.
Impact on Startup Ecosystem
Sebi’s proposed relaxation could significantly benefit startup founders planning IPOs. Many founders accept ESOPs as a form of compensation in the early stages of their companies, often at substantial personal financial risk. Allowing them to retain ESOP benefits even after being classified as promoters ensures that they are rewarded for their contributions without regulatory roadblocks.
Moreover, this policy change encourages more startups to pursue public listings. With greater clarity and flexibility in ESOP regulations, founders can plan long-term ownership strategies without fearing financial setbacks due to reclassification. As India’s startup ecosystem matures, supportive regulatory frameworks play a crucial role in fostering entrepreneurship and attracting investors.
Comparison with Global Practices
International markets, particularly in the United States and Europe, adopt flexible ESOP policies for startup founders transitioning to public markets. In the U.S., startup founders routinely retain stock options and equity incentives, even after becoming significant shareholders or executives in publicly traded firms. By aligning Indian regulations with global best practices, Sebi’s proposal enhances India’s attractiveness as a startup hub and strengthens the country’s position in global capital markets.
Potential Concerns and Counterarguments
While the proposed relaxation offers multiple advantages, some industry experts have raised concerns about its potential implications. Critics argue that allowing founders to retain ESOPs post-reclassification as promoters could blur the distinction between employees and promoters, potentially leading to governance issues.
Additionally, concerns exist around shareholding concentration. If founders retain large ESOP allocations, their influence over the company’s decision-making could increase, raising questions about corporate governance and the protection of minority shareholders. Regulatory safeguards, such as the cooling-off period before an IPO and transparent disclosure requirements, will be critical in addressing these concerns.
Next Steps and Industry Reactions
Sebi has invited public feedback on the proposed changes before finalizing amendments to the regulations. Industry stakeholders, including startup founders, investors, and legal experts, are expected to provide insights into the practical implications of this policy shift.
Early reactions from the startup ecosystem suggest broad support for the relaxation, with many viewing it as a necessary step to align India’s regulatory framework with global standards. Startup founders appreciate the clarity it brings to ESOP eligibility, while investors acknowledge that well-incentivized founders contribute to long-term company growth.
Conclusion
Sebi’s proposed relaxation on ESOPs for startup founders represents a progressive move that addresses a long-standing regulatory ambiguity. By allowing founders to retain stock options despite their reclassification as promoters, the regulator ensures fair treatment and enhances the appeal of public listings for startups.
With appropriate safeguards in place, such as a mandatory cooling-off period, these changes strike a balance between incentivizing founders and maintaining market integrity. As India’s startup ecosystem continues to evolve, such regulatory reforms will play a vital role in fostering innovation, investment, and sustainable business growth.
The consultation process will determine the final shape of these regulations, but if implemented, the changes could mark a transformative shift in how Indian startups navigate the path to public markets. For founders, investors, and the broader ecosystem, Sebi’s evolving regulatory stance signals a positive step toward a more inclusive and transparent capital market environment.