Regulating Founder ESOPs: SEBI’s Landmark Proposal and Its Profound Implications for India’s Public Markets

The architecture of India's startup ecosystem has long been defined by rapid innovation, high-stakes fundraising, and the magnetic pull of equity compensation. At the core of incentivizing early-stage growth lies the Employee Stock Option Plan (ESOP), a powerful tool designed to align the long-term interests of key talent with the company’s success. However, the regulatory framework governing these benefits historically presented a critical fault line, particularly when a thriving startup decided to transition from a private entity to a publicly listed company. The moment a founder, the very architect of the enterprise, was reclassified as a 'promoter' during the Initial Public Offering (IPO) process, their pre-existing ESOP entitlements faced an existential threat.

Recognizing this regulatory anomaly that effectively penalized the individuals responsible for creating substantial economic value, the Securities and Exchange Board of India (SEBI) introduced a pivotal amendment to the SEBI (Share Based Employee Benefits and Sweat Equity) Regulations, 2021 (SBEB Regulations). This reform marks a significant evolution in India’s regulatory philosophy, moving to explicitly protect founders’ ESOPs while simultaneously erecting safeguards against potential misuse. This blog post delves into the genesis of this regulatory conundrum, dissects the specific mechanism of SEBI’s solution, and analyzes the profound governance and market implications that will shape the future trajectory of Indian public listings. The move is a delicate attempt by the market regulator to balance the demands of fostering entrepreneurship and recognizing sweat equity against the imperative of upholding robust corporate governance standards and safeguarding minority shareholder interests.

The Regulatory Conundrum and the Need for a Foundational Fix

To appreciate the gravity of SEBI’s amendment, one must first understand the conflicting definitions and prohibitions embedded within the existing corporate and securities laws. The fundamental principle enshrined in the SBEB Regulations and the relevant rules under the Companies Act, 2013 is the restriction on granting ESOPs to promoters or members of the promoter group. The logic is sound: ESOPs are intended as an employee incentive, a substitute for high cash compensation, to reward performance and commitment without granting immediate control, a benefit already vested in the promoter class.

The challenge arose from the practical reality of startup founding teams, particularly in the New-Age Technology Companies (NATCs). A founder begins as an employee who receives ESOPs as compensation. As the company grows and approaches its IPO, the founder's shareholding, control, or ability to influence company affairs leads to their automatic reclassification as a 'promoter' under the broader definition provided in the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 (ICDR Regulations). This reclassification, triggered solely by the act of filing the Draft Red Herring Prospectus (DRHP), placed the founder in direct conflict with the SBEB Regulations.

Prior to the amendment, founders classified as promoters were effectively required to liquidate, forfeit, or surrender any unvested or unexercised ESOPs before the public listing. This created immense friction and a sense of unfairness. Founders, having dedicated years to building the company and having their compensation structured around these options, found themselves potentially losing out on a significant portion of their earned wealth due to a mere change in regulatory label. In an environment where successive funding rounds perpetually dilute founders' direct equity stakes, ESOPs often serve as the crucial mechanism for maintaining their financial alignment with the company’s long-term value creation.

The regulatory gap was not one of intent, but of application. While the rules sought to prevent promoters from gaining additional, unfair equity after control had been established, they inadvertently ensnared founders whose options were granted years earlier as genuine employee compensation. This deficiency created a regulatory hurdle for IPO-bound startups, complicated legal structuring, and, in some cases, incentivized promising Indian startups to undertake the 'flipping' operation—reincorporating outside of India—to avoid restrictive domestic regulations. The market urgently needed a mechanism that could distinguish between legitimate, early-stage employee compensation and opportunistic, last-minute promoter enrichment. SEBI’s amendment attempts to be that crucial distinguisher.

SEBI's Balanced Amendment: The One-Year Cooling-Off Mechanism

The core of SEBI’s recent amendment, following extensive consultation with stakeholders, centers on a crucial clarification added to Regulation 9(6) of the SBEB Regulations. The amendment states that an employee who is later identified as a 'promoter' or part of the 'promoter group' in the company’s DRHP shall be permitted to retain and exercisetheir options, Stock Appreciation Rights (SARs), or other share-based benefits, subject to a stringent, time-bound condition.

The lynchpin of this regulatory relief is the one-year cooling-off period. The benefit—the ESOP, SAR, or other instrument—must have been granted to the employee at least one year prior to the date when the company’s Board of Directors decides to initiate the process of undertaking an IPO (i.e., filing the DRHP).

This seemingly simple temporal condition serves a dual, strategic regulatory purpose. First, it addresses the fundamental fairness concern. By looking back one year, SEBI acknowledges and protects the benefits granted to founders during their tenure as employees, recognizing their foundational contribution to the company's early and mid-stage growth. It validates the compensation structure agreed upon when the company was still private and the founder's status was unambiguously that of an employee. This provides the much-needed regulatory clarity and certainty that the startup ecosystem had long demanded.

Second, and equally important from a governance perspective, the one-year look-back period functions as a robust anti-abuse mechanism designed to curb regulatory arbitrage. The requirement ensures that companies cannot opportunistically grant large chunks of stock options to founders or promoters just before the public filing to artificially inflate their shareholding or provide an undisclosed financial benefit, thereby undermining the integrity of the IPO process and diluting public shareholder equity unfairly. The buffer period creates a significant disincentive for last-minute grants that lack a genuine nexus to employee performance or long-term compensation.

Moreover, the amendment is a strategic enabler for the 'reverse flipping' phenomenon. As the Indian government and SEBI actively encourage startups that 'flipped' their domicile abroad to return to India before listing, a clear and accommodating ESOP policy is essential. By removing the threat of ESOP forfeiture, SEBI has made the Indian listing market significantly more attractive and competitive, signaling regulatory responsiveness to the unique needs of founders who lead high-growth, technology-intensive businesses. This move helps align the regulatory environment with global best practices where founder equity incentives are typically protected throughout the listing cycle.

Corporate Governance, Investor Trust, and Future Trajectories

While the SEBI amendment has been widely hailed as a progressive and necessary step for the startup ecosystem, its implications extend directly into the realm of corporate governance and investor confidence, sparking an important ongoing debate.

The key concern revolves around what critics refer to as the 'double benefit crisis' or 'double dipping.' When a founder is classified as a promoter—an individual with substantial strategic control over the company—and is simultaneously allowed to retain significant ESOP holdings (an instrument designed for employees who lack that control), the lines between ownership stake, employee incentive, and governance begin to blur. For public shareholders, this raises questions about the pure alignment of interests.

ESOPs are tied to performance and retention, while promoter status confers control and strategic authority. When a promoter holds ESOPs, they effectively receive both control and a specialized employee incentive, leading to a potential misalignment with minority investors who face equity dilution without proportional assurance of accountability. This scenario can create governance risks, particularly concerning the independence of the Nomination and Remuneration Committee (NRC). In a promoter-dominated board, the NRC’s autonomy in approving or overseeing such large grants to the promoter group can be compromised, leading to the risk of preferential treatment or unfair financial gain, issues that have historically surfaced in several high-profile corporate cases.

However, the counter-argument is compelling and often tied to the unique nature of founder-led companies. Founders, even when classified as promoters, often remain the primary operational and intellectual drivers of the business post-IPO. Allowing them to retain their hard-earned options ensures their continued motivation and long-term commitment, which is crucial for the company’s sustained success, thereby aligning their interests with the company's long-term valuation for all shareholders. The one-year cooling-off period is the regulator’s primary tool for mitigating the governance risk, transforming the ESOP from a potential governance loophole into a validated component of long-term compensation.

The amendment’s overall impact on the Indian market is overwhelmingly positive. By providing regulatory certainty and removing an unnecessary impediment to listing, SEBI is strengthening the Indian IPO pipeline. The clarity afforded by the new rule fosters greater trust among founders, investors, and employees. For investors, the transparency regarding founder compensation—knowing that the options were genuinely granted pre-IPO and not as a last-minute perk—can enhance their confidence in the company’s internal controls and fairness.

Looking ahead, the discussion must now shift from the eligibility of ESOP retention to the quality of their governance. Future steps for the regulator and the corporate sector may include:

1. Mandatory Performance-Linked Vesting: Imposing stricter criteria that link the exercise of promoter-held ESOPs to long-term, measurable, pre-disclosed performance metrics rather than merely time-based vesting.

2. Independent NRC Oversight: Strengthening rules to ensure the NRC responsible for approving or overseeing ESOPs for the promoter group is entirely independent and free from promoter influence.

3. Enhanced Disclosure: Requiring more detailed and granular disclosures in the DRHP regarding the rationale and valuation of founder ESOPs.

In conclusion, SEBI’s amendment on founder ESOP retention is a seminal moment for the Indian startup ecosystem. It successfully resolves a significant regulatory bottleneck that hindered domestic listings and unfairly penalized long-serving founders. By introducing the one-year cooling-off period, the regulator has struck a necessary, albeit fine, balance: encouraging wealth creation and innovation by protecting founder equity, while installing a fundamental safeguard against the opportunistic exploitation of the regulatory framework. This measured intervention ensures that India’s public markets can continue to attract and sustain the listing of high-growth technology companies, fostering a regulatory environment that is both nurturing and responsible. The success of this policy will ultimately be measured not just by the number of IPOs it enables, but by the quality of corporate governance established in their aftermath.