Budget 2025 Falls Short on ESOP Tax Reforms

Indian startup employees continue to face uncertainty as the Union Budget 2025 last week remained silent on one of their key wishlist items—the taxation policy around Employee Stock Ownership Plans, or ESOPs.

The ESOP Tax Burden 

The current ESOP taxation framework imposes a dual burden on employees as they are taxed at two stages: when employees exercise their options and when they eventually sell the shares.

As a result, before shares are sold, employees may be taxed on the notional gains, a significant cash burden when exercising ESOPs due to the tax obligation on notional gains, even without realizing actual cash. Finding external sources of funding is also not very easy, as the shares of unlisted companies are not accepted as collateral by banks or Non-Banking Financial Companies (NFBCs). If they fail to secure funds, ESOPs may lapse, leading to lost wealth opportunities.

While the government has offered deferred tax payments for certain startups, these measures are mostly absent for companies that are unlisted or at a growth stage, leaving employees without much support.

Leading up to Budget 2025, many believed that the government would switch to a single-point taxation system where employees would only be required to pay taxes when they sold their shares, similar to capital gains taxations. However, the budget did not make any significant changes, with experts calling for stronger reforms around ESOPs.

“Without the right policies, ESOPs provide very little benefit for the employee,” said Nitin Agarwal, co-founder of ESOPPDHAN, a company dedicated to providing liquidity solutions to ESOP holders.

Rohit Kapoor, CEO-food marketplace Swiggy, also echoed these sentiments in an earlier conversation with Moneycontrol, calling the ESOP taxation for holders of ESOPs as "highly egregious in India".

The ESOP Liquidity Burden
 
Even when employees receive ESOPs as part of their compensation, converting them into cash remains difficult due to the lack of structured buyback programs or secondary market opportunities.

A recent examples of this liquidity challenge is Dunzo, where the company’s financial struggles left over 200 employees unable to cash in on their ESOPs. With the CEO’s exit to Flipkart, Dunzo failed to honour payments to ESOP holders and eventually lay off their employees.

“ESOPs can be a transformative tool for both employees and employers. One should encourage employees to exercise ESOPs in the early stage, where the the Fair Market Value (FMV) of the company is at lower level. This can help reduce employees’ overall tax liability, even under the existing tax regime. By exercising early, employees minimize their taxable perquisite value, leading to lower out-of-pocket tax payments.” says Agarwal. This is why companies like ESOPPDHAN are stepping up to tackle the liquidity issues that plague the ESOP ecosystem by helping employees take control of their financial decisions.

Agarwal explains that the ESOP ecosystem needs solutions like liquidity options, tax deferral mechanisms, tax advisory, and awareness of tax arbitrage to help employees unlock the full potential of their ESOPs. Through their offerings, ESOPPDHAN, is focused on providing loans to employees of unlisted companies to facilitate the exercise of their vested ESOPs.

“Some of our key loan features that are there are no EMIs, personal guarantees or collateral need. The loan being a nonrecourse in nature and repayment linked to liquidity event,  even if the company collapses or winds up, employees have no repayment obligations,” Agarwal said.

ESOP Challenges Persist

Despite growing recognition of the need for ESOP liquidity, the process continues to face strong resistance from venture capitalists (VCs) and shareholders. Many investors argue that allowing employees to exercise ESOPs too early complicates the capitalisation table, dilutes ownership structures, impacts company valuation, and reduces long-term employee commitment. Additionally, investors fear that enabling employees to cash out their ESOPs could diminish their incentive to stay with the organisation. The challenge, therefore, lies in finding a balanced approach that benefits both employees and investors.

Agarwal explains, “We are working to address both issues—providing liquidity to employees when the FMV of the company is lower, thereby enhancing their wealth creation opportunities, while ensuring that employees continue to hold shares without imposing financial obligations or buyback commitments on the company. If the investor community could recognize the long-term benefits, they would see how engaged employees with liquid shares could be a significant HR asset for companies.” However, securing approvals from investors and company boards remains a major hurdle.

The liquidity challenge, compounded by unfavourable taxation laws, places employees in a difficult position. Without broader industry acceptance from investors and stakeholders, ESOP liquidity solutions remain an uphill battle—leaving employees trapped in a system where they own valuable shares on paper but struggle to realize their actual worth.

Global Precedents
 
Agarwal highlights that this challenge has been resolved in other parts of the world. The United States, for example, now has a more supportive ESOP framework that allows for deferred tax payments on certain stock option with programs like the ESOP Association and the QSES tax exemptions.

Moreover, the investor sentiment in these countries has been favorable. Companies like Facebook, Google, and Airbnb are now offering ESOPs are part of their employee compensation to attract and retain talent. 

“We believe that employees deserve better,” Agarwal says.

Startups are the future of India’s economy, and their employees are the backbone of this future. As India’s startup ecosystem matures, it’s critical to recognise the hard work of the employees in driving growth. This requires both policy and industry to come together to make ESOPs a truly rewarding tool for employees.

“We need a mindset where ESOPs can function as they intended—to align employees with company success and offer them a stake in that success.”

Article by- Shravan Shroff, Director, ESOPPDHAN

Moneycontrol Journalists are not involved in creation of this article.