How to Structure an ESOP Scheme in India: Direct Route vs Trust Route, Decided Properly

The legal foundation, briefly

For a private limited company in India, employee stock options live under Section 62(1)(b) of the Companies Act, 2013, read with Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014. Together they require a shareholder approved scheme, and Rule 12 writes some non negotiables into every Indian ESOP: a minimum vesting period of one year, disclosure of eligibility criteria and exercise price methodology in the explanatory statement, a register of options in Form SH-6, and restrictions on who can receive options. Promoters and directors holding more than ten percent of equity are generally excluded from ESOPs, though eligible startups enjoy a window of relaxation from these exclusions for their early years. Whichever route you pick, the ceremony of birth is the same: the board approves the draft scheme, shareholders pass a special resolution, the resolution is filed with the Registrar of Companies in Form MGT-14, grants are made by grant letters, options are recorded in SH-6, and when employees eventually exercise, share allotments are filed in Form PAS-3. We walk through that sequence step by step in our companion article on ESOP implementation. Where the two routes diverge is what happens between grant and the employee actually holding shares.

The direct route: simple, and simplicity compounds

In the direct route, the company itself grants options to employees. When an employee vests and exercises, the company issues fresh shares straight to the employee, files the allotment, and updates its cap table. The appeal is honest simplicity. There is no separate entity to create, fund, govern, or audit. Every grant and exercise is visible on the company’s own records, which investors and their lawyers love, because diligence on a direct route ESOP is an afternoon’s work. Costs stay low, and the scheme is exactly as complicated as your option pool spreadsheet. The trade-offs are structural. Fresh issuance means dilution happens at exercise, so your fully diluted cap table must always be read with the pool in mind. Every exercise event is a corporate action, board allotment, PAS-3 filing, which is trivial at ten employees and a process at four hundred. And the company cannot easily recycle shares: when a departing employee’s vested shares need a buyer, a private company buying back its own shares walks through the formal buyback provisions of the Companies Act, which are real machinery, not a signature. For most startups from incorporation through Series A or B, these trade-offs are cheap, and the direct route is the sensible default. Picture a twenty person SaaS company, call it Falcon Labs, granting options to its first fifteen hires. Direct route, clean SH-6 register, exercises batched once or twice a year. Nobody has ever regretted that setup at that size.

The trust route: machinery that earns its cost at scale

In the trust route, the company settles an employee welfare trust, an independent entity with trustees. The trust acquires a block of shares, either fresh shares subscribed from the company or, subject to conditions, shares bought from existing shareholders, and holds them. When employees exercise vested options, the trust transfers shares to them. Now the advantages appear at scale. The dilution event happens once, when the trust is funded, rather than dribbling through dozens of exercise events, which keeps the cap table stable between funding rounds. The trust can act as an internal marketplace: it can receive back shares from departing employees and reallocate them to new hires, giving the company a liquidity and recycling mechanism the direct route lacks. For companies running structured buyback programs for employees, a well governed trust is the natural engine. It also suits groups, where one trust can serve employees across entities. The costs are equally real. You are creating and governing a separate legal entity: trust deed, trustees with fiduciary duties, books, audits, and income tax filings for the trust itself. Funding the trust raises its own questions, since Section 67 of the Companies Act restricts a company financing the purchase of its own shares, with carve outs for employee benefit trusts that must be navigated precisely, including limits linked to paid up capital and reserves. Trustee decisions need governance hygiene, because a trust run casually is a liability with a deed. And for listed companies, SEBI’s Share Based Employee Benefits regulations wrap the trust route in a further layer of rules, a preview worth knowing if an IPO is in your ten year story.

The decision framework

Ask five questions. How many employees will hold equity in five years: below a couple of hundred favours direct, above it starts favouring trust. Will you run recurring employee buybacks or liquidity programs: recurring programs favour trust. Is there a group structure or an IPO on the horizon: both favour trust, or at least a design that can migrate. How strong is your internal secretarial muscle: trusts punish weak administration. And what does your lead investor expect: some funds have firm preferences, and it is cheaper to know before you draft. The honest pattern across Indian startups: begin direct, migrate to a trust if and when scale, liquidity programs, or a pre IPO restructuring justify it. Migration is work, but it is routine work for advisers, and far cheaper than running a trust you never needed.

Can AI help you design and run an ESOP?

Yes, in the administration where ESOPs actually decay. AI tools now draft first cut scheme documents against Rule 12’s checklist, model dilution across future rounds under both routes, track vesting schedules and exercise windows for every employee, and auto generate the SH-6 register entries and grant letters that companies chronically forget. For a founder, asking an AI assistant to simulate “what does our cap table look like if forty percent of options exercise before Series C” turns a spreadsheet weekend into a coffee break. The boundary is the usual one and it matters more here than most places: an ESOP is a security, a contract, and a tax event stapled together, and choices like trust funding mechanics under Section 67, promoter exclusions, or startup relaxations are legal judgments where a confidently wrong AI answer becomes an expensive rectification. Draft with the machine, decide with a qualified human.

When to Review This

• The direct route issues shares from the company at each exercise: simple, transparent, mildly repetitive. The trust route interposes a share holding trust: powerful for scale, recycling, and liquidity programs, at the price of a second entity to govern and fund lawfully. The law, Section 62(1)(b) and Rule 12, is the same skeleton under both. Choose on your five year employee count, your liquidity plans, and your administrative honesty, and remember that the best ESOP structure is the one your company will actually maintain.