SEBI’s New ESOP Rule: Fair Play or Flawed Plan?

Shruti Gala

(Student at Bennet University)

INTRODUCTION

Recently, on March 20, 2025, the Securities and Exchange Board of India (SEBI) published a consultation paper suggesting modifications to the SEBI (Share Based Employee Benefits and Sweat Equity) Regulations, 2021. The proposed changes are particularly relevant for New-Age Technology Companies (NATCs) that are preparing for public listing. Among the slew of proposed changes lies a contentious issue - the introduction of a one-year look-back rule option under Employee Stock Option Plans (hereinafter referred to as ‘ESOPs’). Under this rule, founders would be allowed to retain and exercise the ESOPs granted before a specific cut off date, even after the Draft Red Herring Prospectus (DRHP) is filed.

This is a welcome change, particularly in case of tech startups where such ESOPs serve as vital compensation mechanisms for founders who usually take a pay cut or reduced salaries in exchange for an equity upside. Additionally, ESOPs also aid in offsetting the inevitable dilution of founder shareholdings across multiple fund raising rounds. However, there is  significant ambiguity surrounding what would be considered as the starting point for this one-year look-back period, raising concerns.

This article aims to examine how SEBI’s ambiguity with the rule could lead to regulatory challenges and governance issues. By comparing India’s approach with global practices, it further aims to offer recommendations to refine the rule in a manner which would truly benefit the founders while protecting the investors interest.  

UNDERSTANDING THE PROPOSED ONE-YEAR LOOK-BACK RULE

SEBI’s proposed amendment intends to resolve a catch-22 situation that has particularly long troubled NATCs aiming for a public listing. As per the current regulations, founders must be classified as promoters when the DHRP is filed. However, the Companies (Share Capital and Debenture) Rules, 2014, prohibit promoters and members of promoter groups to hold or receive any ESOPs. Thus, founders who are yet to be classified as promoters remain uncertain whether the ESOP would remain binding once they receive the designation of a ‘promoter’ when the DRHP is filed. This creates a dilemma for many NATCs where ESOPs have acted as an incentive for founders to focus on the long-term performance of the company, in spite of the dilution that takes place during the funding rounds.

With the introduction of the look-back provision, all ESOPs granted before the one-year pre- IPO period remain valid regardless of the founders’ subsequent designation as a promoter. Thus, founders will be allowed to hold, exercise and avail all the ESOPs which were granted at least one year prior to the IPO period. However, SEBI has not clarified when the said one-year look back period commences. There is ambiguity concerning whether the period commences from: (i) the date on which an in-principal fund-raising resolution was made; or (ii) the formal IPO-approval resolution; or (iii) when the DRHP is filed. Such ambiguity hampers the effectiveness of the well-intended amendment and not only causes confusion for the companies but also creates potential regulatory hurdles.

CHALLENGES

Let us assume a hypothetical scenario where a tech company opts for a public listing. In January 2024, the Board of Directors resolve, in principle, to approve the IPO process. However, the formal approval is granted in July 2024. Accordingly, the DRHP is filed in December 2024. Assuming that the founder was granted his ESOPs in June 2023, there is a clear confusion about whether he will be able to hold the said ESOPs under the one-year rule. The answer fully depends on what SEBI considers as the starting point of the IPO period - which the consultation paper has unfortunately left open.

Since there is no specific commencement date, companies might have conflicting interpretations regarding the validity of such ESOPS which may further give rise to litigation battles between SEBI and the companies. Moreover, companies may choose to exploit the grey area in their interest by making strategic placements of their board approvals and DRHP filing within the one-year period, thus defeating the purpose of the well-intended rule.

The ambiguity creates tangible risks which may prove to be detrimental to the Indian startup ecosystem. As discussed earlier, startup founders usually rely on ESOPs to make up for the pay cut during the funding period. Thus, ESOPs act as an important incentive for founders to stay motivated towards the long-term planning of the company. If founders are at a risk of losing these benefits due to misinterpretation of a rule, it not only deters talent but also leads to misalignment of interests between the founder and investors. Additionally, regulatory uncertainties may lead to a delay in the IPO filing process which may further distort optimal market-timing decisions. In India, MobiKwik’s IPO faced delay due to heightened regulatory scrutiny for fintech businesses. Similarly, Ant Group’s $37 billion IPO in China and Hong Kong was suspended due to regulatory tussle in the Chinese stock market.

Beyond the direct consequences on the founders, there are broader market implications of such an ambiguous rule. Investors value transparency and consistency, any scope of ambiguity in regulatory compliance discourages them from investing. For example, when there was regulatory ambiguity surrounding cryptocurrency due to conflicting stance of RBI and SEBI, many companies including ZebPay shut down operation in India.  During due diligence, uncertainty around founder’s equity could raise red flags in the minds of investors. A dearth of explicit rules could also lead to unequal treatment of comparable companies. Two companies working under the same conditions may receive different treatment of the rule based on differences in their internal process of conducting IPOs. Such differential treatment undermines creating a level playing field in the competitive environment of public offerings. For instance, the method of granting an ESOP, whether through trust route or through the direct route leads to a difference in the obligations and compliance requirements. 

RECOMMENDATIONS

To enhance regulatory precision and efficiency, SEBI should clearly define the point of beginning for the one-year look-back period for founder ESOPs. The current uncertainty on whether the period will run from the in principal approval of fundraising, the official IPO clearance, or the DRHP filing exposes unnecessary compliance hazards. A ‘cut-off date’ expressed with clarity would maintain regulatory uniformity and afford certainty to the company and the investor. Increasing requirements of disclosure would further enhance the framework. SEBI should require companies to disclose detailed details of ESOP grants as part of IPO-related filings, including the grant date, vesting pattern, and effect on shareholding pattern. By ensuring fair and accurate reporting, the investors are given a proper picture of the company’s equity compensation structure and preventing the possibility of last-minute ESOP grants. This would also aid SEBI in ensuring regulatory surveillance while providing companies with the autonomy to structure employee incentive programs efficiently. Sharpening such disclosure standards would bring the scheme into line with investor expectations and enhance overall market confidence.

CONCLUSION

SEBI’s proposed amendments are undoubtedly an important step taken to further encourage India’s rising startup economy. The benefit granted to the founders indicate SEBI’s awareness of how high-growth firms work and the importance of rewarding their leaders. However, merely granting benefits is not enough, SEBI needs to take the required steps to ensure that the execution of said benefit is done accurately. The uncertainty over the one-year look-back period reflects a wider dilemma in India's regulatory strategy where there has been a struggle with respect to balancing innovation with oversight and allowing flexibility while maintaining order. As India's digitally transforming companies compete in international capital and talent markets, a regulatory system that injects unnecessary uncertainty into their operations handicaps them in both markets. For instance, SEBI’s insistence on the enforcement of pro-rata and pari-passu rights in AIF to ensure fairness and equality among all investors, inadvertently curbs financial innovation.  Through the adoption of clarity, transparency, and globally tested practices, SEBI can establish a framework that enhances governance while empowering the next generation of innovative Indian businesses on their path from startup to listed entity.