Between Control and Contribution: A Welcome Reform or Regulatory Grey Area For Startup Founders?

Introduction: Founders and the problem of classification

India’s startup ecosystem has seen an exponential boom in the recent years, with the country emerging as the third-largest startup ecosystem globally. The startup wave began with a few individual entrepreneurs. Over time, supported by venture capital inflows, digitization and policy reforms, it has evolved into a strong network of founder-led startups. However, unlike traditional promoter-led companies, these founder-led startups are often bootstrapped, making it difficult to retain talented employees. This is where ESOPs come in as an essential tool to incentivize high-performing individuals, more so when the enterprise is in its initial growth period, the capital is scarce and the monetary compensation is low. ESOPs are a form of employee benefit plan which are released so that the employees can have ownership of the company they are working for, over a period of time. In startups, as the business grows more and post various rounds of investment, the shareholding of the founders gets reduced drastically and, in such situations, the founders are given ESOPs in the place of upfront remuneration for their long-term commitment.

However, the current regulations related to ESOPs in India, have failed to acknowledge the contributions of startup founders. Under the current laws, the regulatory formality of classifying founders as promoters makes them ineligible to hold ESOPs, creating a vicious paradox for them. To address this dilemma, the Securities and Exchange Board of India (SEBI) had floated a consultation paper in March 2025 and has approved it in its board meeting dated June 18, 2025. However, the proposed changes are still awaiting formal notification and enforcement. Through this proposal, SEBI has now approved amendments to the SEBI (Share Based Employee Benefits and Sweat Equity) Regulations, 2021 (SBEB & SE Regulations). In this article, the authors aim to critically analyse the proposed amendment, its practical implications and contextualize it within the real-world examples.

The old regime: Understanding the rationale behind exclusion of promoters

As per Section 62(1)(b) Companies Act, 2013 read with the Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014 (SCDR Rules), promoters and directors who hold more than 10% of equity shares are prohibited from receiving ESOPs. Furthermore, the definition of employees under Regulation 2(1)(i) of the Securities and Exchange Board of India (Share Based Employee Benefits and Sweat Equity) Regulations, 2021 (SBEB & SE Regulations) explicitly excluded promoters from being classified as employees hence, promoters were barred from receiving ESOPs. The rationale behind this restriction was that ESOPs are tools for rewarding employees and not for enriching promoters. This principal is an important corporate governance norm as it prevents the promoters from reaping benefits under the guise of rewarding employees.

However, this restriction failed to take into account the fact that in startups, the lines between promoters and employees are blurred. To take into account this challenge, an exemption was given to startups which are registered under the Department for Promotion of Industry and Internal Trade (DPIIT) under the proviso of Rule 12 of SCDR Rules, which would allow the promoters to hold ESOPs. However, this exemption was limited only to private companies, limited liability partnerships and registered partnerships and it lasted only for a period of 10 years from the incorporation. This exception was not extended to the public companies as there is a higher degree of risk associated with public companies because of their extended and diverse shareholding structure which leads to unique governance challenges.

A well-intentioned patch: Proposed Amendments to the SBEB & SE Regulations

SEBI has proposed to insert an Explanation 2 to Regulation 9(6) of the SBEB Regulations, 2021 in order to strike a balance between incentivizing founders and protecting investors. This provision would allow the employees who are identified as promoters during the IPO process, to continue holding the ESOPs that they were granted before they were classified as promoters. However, one condition has been attached to it which states that the employees-turned-promoters can only continue to hold those ESOPs which were granted to them at least one year before the company’s IPO decision.

The rationale behind this one-year cooling off period is to protect the investors from opportunistic founders who are granted ESOPs right before the listing for self-enrichment. While aiming to ensure that founders don’t lose their well-deserved compensation, it also would also ensure that ESOPs are not used retroactively in order to reward insiders before an IPO.

Fractures in the framework: The Shortcomings of the Proposal

SEBI’s proposed amendment, though well-intentioned, has some serious loopholes. Firstly, although a one-year cooling off period is proposed to be given under the amendment, it has not defined the one-year period. Currently, there is uncertainty on whether the period will run from the first approval of fundraising by the Board, the official clearance of the IPO, or the DRHP filing. The absence of a clear ‘cut-off date’ leads to unnecessary difficulty in approving the compliance requirements of the company and keeps the company and its investors in grey. To take a hypothetical scenario, if a startup resolves to explore an IPO in February, passes the formal resolution in August and files the DRHP in November, the founder who was granted an ESOP in June would remain perplexed by regulatory dilemma.

Secondly, the SBEB & SE Regulations, 2021 define the term “promoter” to hold the same meaning as it holds in the Securities Exchange Board of India (Issue of Capital and Disclosure Requirements) Regulations, 2018 (ICDR Regulations). Under the ICDR Regulations, a promoter is defined as a person who has been named as such in the offer documents or annual returns, or someone who has direct or indirect control over the company’s affairs, or gives directions to the Board. While SEBI’s proposed amendment is progressive, it fails to solve the foundational problem which is the outdated classification of “promoter”. Even founders, who no longer hold significant equity or don’t have sufficient control in the company, are classified as promoters just because their names were mentioned in the offer documents. This makes such founders ineligible to hold ESOPs.

The recent case of Paytm highlights this dilemma. The founder of Paytm, Vijay Shekhar Sharma, held over 10% equity before the IPO but he brought his equity just below the threshold by transferring the excess shares to a family trust. Although, Paytm stated itself to be a “Professionally managed Company” in its DRHP, Sharma’s classification was brought under scrutiny by SEBI. Eventually, proceedings were initiated against him, his ESOPs were cancelled and he was barred from being granted fresh ESOPs for three years. This instance highlights the repercussions of unclear timelines and classification guidelines.

Another instance could be when Healthvista India claimed in its DRHP that it had no identifiable promoters. However, after the intervention of SEBI, it reclassified its founders as promoters in 2023. This shift led to scrutiny of pre-IPO ESOPs held by founders. This case reflects how sometimes founders have to be reclassified as promoters for regulatory compliance even though they might not have any actual control of the company.

The shift towards a standard of “persons-in-control” was suggested by SEBI in its consultation paper dated May 11, 2021 and was finalized in its board meeting dated Aug 6, 2021. However, no steps were taken to implement this change. Hence, by not providing any clarification in this regard, the proposed amendment is merely a patchwork solution which is disconnected with the corporate reality.

Conclusion: Reforms and International Perspective

The blanket restriction on ESOPs, though stemmed from the intention to curb abuse, but also precluded legitimate rewards for the promoters who worked as employees. This proposed amendment encapsulates the intent to harmonise the regulations with commercial interests. The shift in position regarding the Promoter’s ESOPs post-IPO demonstrates a legitimate intention to provide incentives for promoters without jeopardising the interests of other stakeholders. Yet the proposed amendment presents unique implementation challenges and legal ambiguities that need to be cleared to operationalize the objectives of the amendment.

A principled approach is imperative to effective implementation of the proposed amendment as there are various challenges that need a precise approach. Firstly, the term ‘IPO Decision’ should be defined in a way that gives an exact timeline that can be objectively ascertained. Ideally, it should be fixed at the board’s formal approval of the IPO as if offers a clear point to distinguish pre-IPO planning and last-minute grants for self-enrichment. Secondly, all the disclosures regarding ESOPs must be mandated, which would include IPO documents detailing grant dates, vesting period and the change in shareholding pattern. This is crucial to ensure transparency, which is essential in order to distinguish misuse from strategic flexibility. Thirdly, with companies increasingly shifting towards professional management and dispersed ownership, it is time to move beyond legacy labels like ‘Promoter’. The regulations should instead be focused on identifying actual control.

The proposed amendment keeps up with the broader global approach. For instance, in Germany, there is no restriction on which employees can receive benefits equivalent to ESOPs, but it is prohibited to grant them to the supervisory board and external consultants. In the USA, there are no restrictions on promoters from receiving ESOPs, but cannot be granted to highly compensated employees. In Singapore, public companies are mandated to obtain approval of independent shareholders before granting ESOPs to an employee who has a shareholding of more than 15% or if the grant of ESOPs will increase the shareholding of employees to more than 5%.

The regulations across jurisdictions are focused on accountability and fairness rather than a blanket prohibition. The alignment of the Indian approach with Global models is a welcome step. However, it needs to be ensured that promoter participation happens in a fair and transparent way so that the interests of other stakeholders are not jeopardised. The focus should be on creating a balance between preventing abuse and rewarding hard work, this will pave the way for a market which is secure and rewarding.