Regularising Informal ESOP Promises: the Founder's Clean-Up Guide

Almost every fundraise I have sat through has this moment. The investor's lawyer works through the cap table, then asks a quiet question: what about the equity you promised the early team? Out comes an offer letter with one hopeful line — "2% ESOP on joining". An email thread. A spreadsheet last touched two years ago. None of it is a scheme. All of it is a problem, because the people holding those lines believe they own something, and right now, legally, they do not.

The good news first: most informal promises can be cleaned up. The honest news next: cleaning up does not mean converting the old words into shares by declaration. It means building, now, the formal structure that should have existed then — and mapping each old promise into it, person by person, with fresh approvals and real grant dates. Here is how that sequence runs, and where it stops working.

A promise in an offer letter is not a grant

Start with what an option actually is. Under section 2(37) of the Companies Act, 2013, an employees' stock option is the right to purchase or subscribe for shares at a future date at a pre-determined price. Shares are offered to employees under section 62(1)(b), and for an unlisted company Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014 sets the route: a scheme, approved by the shareholders by special resolution, with the disclosures listed in Rule 12(2) made in the explanatory statement before that vote.

Until that machinery exists, there is no option to point to. No scheme means no grant. No grant means no vesting, no exercise, and certainly no shares. Even a properly granted option gives its holder no dividend, no vote and no other benefit of a shareholder until shares are actually issued on exercise — Rule 12(6)(c) says so in terms. A line in an offer letter sits one full step behind even that. What the employee holds is, at best, a contractual claim: a promise that may or may not be enforceable depending on how certain its wording is and what the surrounding correspondence shows. I am not going to tell you how any individual dispute would end, because nobody honestly can — the paper decides, case by case.

There is a second defect, quieter but just as real. Most informal promises are written as percentages. "2% when we raise." Two per cent of what — the capital on the day of the promise, the day of the raise, fully diluted or not? Every round moves the denominator. A percentage promised in 2023 does not translate itself into a number of options in 2026. Somebody has to do that conversion, write it down, and get the person to agree it. That conversation is the heart of the clean-up.

Think of it the way land records work in the districts most of our families come from. A family understanding may decide who tills a plot for years, and everyone in the village knows whose it is. But the name that counts — the one a buyer, a bank or a court acts on — is the name in the register. An informal ESOP promise is the village understanding. The scheme, the grant letter and the register entry are the record of rights. Diligence reads the register, not the understanding.

Step one: audit every promise before you draft anything

Do not start with the scheme document. Start with a list. Pull every place equity was ever mentioned: offer letters, increment and promotion letters, emails from founders, chat messages that were screenshotted and kept, the cap-table spreadsheet, board minutes that recorded an intention. Founders are often surprised by their own list. That surprise is the point — find it in your office, not in the investor's review.

For each promise, record five things:

• Who — name, and their status today: still an employee, now a consultant, or already gone.
• What — the exact words used. A percentage, a number of shares, a value, or just "ESOPs as per company policy" with nothing behind it.
• The paper — signed letter, unsigned draft, email, verbal only. Signed paper carries different weight from a corridor conversation, and your approach to each should differ.
• Any clock already running in the person's head — most promised employees believe vesting started the day they joined. Write down what they believe; the gap between that belief and the legal position is where disputes grow.
• Any money that moved — occasionally a founder has taken a token amount against a promise. Note it. It changes the character of the claim.

Only when that list is complete do you sort it. And it sorts, almost always, into three piles with three very different answers.

The three piles: employees, consultants, and people who have left

Pile one — people still employed. This is the pile the law can help with. Rule 12 grants can be made to "employees" as the Explanation to Rule 12 defines them: a permanent employee of the company, a director who is not an independent director, and the equivalent employees and directors of a subsidiary or holding company — with promoters and directors holding more than 10% kept out, subject to a relaxation for startups in their first ten years. If the person is inside that definition today, their old promise can be mapped to a formal grant under a new scheme. Pile one is drafting and approvals work. It is very doable.

Pile two — consultants and advisors. Here I have to be blunt, because loose advice floats around on this point: consultants and advisors are not "employees" under the Rule 12 Explanation, and no drafting inside a Rule 12 scheme can bring them in. A promise made to a consultant cannot be regularised into a Rule 12 grant. Full stop. Nor does sweat equity rescue the position in the ordinary case. Sweat equity shares under section 54, read with section 2(88) and Rule 8, are shares issued to directors or employees for know-how, intellectual property rights or value additions — the Rule 8 definition of "employee" is the same permanent-employee-and-director frame. A pure consultant, who is neither, is outside that route too.

What pile two actually offers is a commercial settlement, honestly labelled. Cash, agreed and documented. Or a phantom or SAR-style arrangement — a contract that pays the person cash linked to share value at a future event, without issuing a single share. Or, where the relationship is genuinely becoming permanent, a real change of status first — employment or a board seat — after which the equity conversation can restart on a lawful footing. Each route has its own conditions. Sweat equity, where it does fit, carries its own caps — in a year, not more than 15% of existing paid-up equity capital or shares of an issue value of ₹5 crore, whichever is higher; never more than 25% of paid-up capital at any time (50% for a startup company, within ten years of incorporation) — plus a special resolution, a registered valuer's price, and a three-year lock-in. Do not let anyone sell it to you as the informal-promise dustbin. It is a narrow instrument for a defined job.

Pile three — people who have already left. The hardest pile, and the one founders postpone. A Rule 12 grant is a grant to an employee; once employment has ended, the route that works for pile one is, at best, doubtful, and I would not build a diligence file on it. What remains is negotiation: a documented settlement — cash, or occasionally shares through a route that does not depend on employee status, structured with specific advice — recorded in writing, with the old promise closed out expressly. Our guide to what happens to ESOPs when an employee resigns covers the leaver mechanics for options that were properly granted; pile three is the messier situation where nothing was ever granted at all. The worst outcome here is silence. A departed employee holding a signed offer letter with an equity line is a claim that does not expire because you stopped replying to it.

Step two: adopt the scheme the promises should have had

With the audit done, build the scheme — sized for the mapped pile-one grants plus the hiring still to come. If you are fixing the pool number at this stage, our post on how big an ESOP pool should be works through that sizing question in full. The approval chain for the scheme itself is fixed by Rule 12:

1. Board approval of the draft scheme and of the general meeting that will adopt it.
2. Shareholder approval by special resolution, with an explanatory statement disclosing what Rule 12(2) lists: total options, classes of employees entitled, the eligibility appraisal process, vesting requirements and period, the maximum vesting period, the exercise price or its formula, the exercise period and process, any lock-in, maximum options per employee and in aggregate, the valuation method, when vested options lapse, and the exercise window after cessation of employment, along with a statement on the accounting standards that will be followed.
3. Separate resolutions where Rule 12(4) demands them — a separate resolution for grants to employees of a subsidiary or holding company, and a separate resolution where identified employees are to receive, in any one year, options equal to or exceeding 1% of the issued capital, excluding outstanding warrants and conversions. In a clean-up this second one bites often: the early hire who was promised the most is frequently the person who crosses 1%.
4. File Form MGT-14 with the Registrar within 30 days of the special resolution.
5. Check authorised capital headroom. Options become shares by fresh issue on exercise, and issued capital cannot exceed the authorised capital in the memorandum. If the pool does not fit, the capital increase goes on the approvals list now, not at exercise time.

Step three: grant letters that map old words to new options

Now, and only now, the individual paperwork. The board (or a committee the scheme authorises) approves each grant, and each pile-one employee receives a grant letter that does three things. It states the grant in numbers — this many options, at this exercise price, on this vesting schedule. It fixes the grant date as the real date of the board's approval. And it records, in plain words, that this grant is made in settlement of the earlier assurance described in it, so the old line and the new letter cannot both be run later as two separate claims.

On the grant date, be uncompromising: no backdating. Not to the joining date, not to the offer-letter date, not to make the paperwork look tidier than it is. A backdated grant is the fastest way to turn a clean-up into a diligence finding of its own, and it unravels the tax and vesting positions built on it. The grant date is the date the grant is actually made. Everything else in this exercise is defensible precisely because that date is honest.

Each grant then goes into the Register of Employee Stock Options in Form SH-6, which Rule 12(10) requires the company to maintain, entering the particulars of every grant forthwith — at grant, not at exercise, not at transfer. This register is one of the first documents a diligence team calls for. In a clean-up file, the SH-6, the scheme, the resolutions and the grant letters should tell one consistent story, with dates that line up.

The vesting clock: the conversation founders dread

Here is the point that makes regularisation hurt. Rule 12(6)(a) requires a minimum period of one year between the grant of an option and its vesting. That floor cannot be waived by the scheme, by the board, or by sympathy. A grant made this month cannot vest this month — even for the engineer who was promised equity three years ago and has, in every moral sense, already waited out a cliff.

What the scheme can do — a design choice, to be made openly and stated honestly to the people affected — is decide how past service counts within the space the floor leaves. It may set first vesting at the one-year mark and spread the balance over a shorter period for regularised grants, so the total wait reflects the person's history. It may treat regularised grants exactly like new grants, on a standard four-year shape. Both are lawful. What it may not do is pretend the clock started in 2023. Say this plainly to the employee: the law gives past service weight only through the shape of the schedule, not through a backdated start. People accept hard positions they understand. They litigate positions that were fudged for them.

Cliff design follows the same logic. A one-year cliff that coincides with the statutory first-vesting point is the clean pattern: nothing vests before month twelve, the first tranche vests then, and the scheme's leaver provisions — what happens on resignation, termination for cause, death or disability — apply from the scheme document, not from whatever the old email happened to say.

Tax and paper: what the clean-up triggers, and what it does not

Regularisation itself — scheme adoption, grant letters, SH-6 entries — is not a tax event for the employee. Tax arrives later, at exercise. When vested options are exercised and shares are allotted, the value of the shares is a perquisite taxed as salary under section 17(2)(vi) of the Income-tax Act, 1961: the fair market value on the date of exercise, less the amount the employee actually paid. For unlisted shares, that value is determined by a merchant banker under Rule 3(8) of the Income-tax Rules, 1962, on the exercise date or a specified date not more than 180 days before it. The employer deducts tax at source on the perquisite. A later sale is a separate capital-gains event, with the fair market value taken at exercise becoming the cost of acquisition.

Settle a promise in cash instead — the usual pile-two and pile-three outcome — and the character changes completely. For an employee, a cash payment in place of promised equity is taxed in their hands as salary-type income, with tax deducted at source by the company; there is no perquisite computation and no shares. Get the settlement recorded as full and final for the equity promise, or you have paid once and kept the claim.

And keep the forms in their correct places, because diligence reads them as a timeline. Form MGT-14 belongs to the special resolution, within 30 days of its passing. The SH-6 register belongs to the grant, entered forthwith. Form PAS-3 — the return of allotment — belongs only to allotment: it is filed within 30 days after shares are actually allotted on exercise, and a clean-up that has reached only the grant stage has no PAS-3 to file and should not invent one. A file that shows each form at its own trigger reads as a company that understands its scheme. A file with forms at the wrong triggers reads as decoration.

What a diligence-ready clean-up file looks like

• The promise audit itself — every promise found, its paper, and which pile it fell into.
• The scheme document, the board minutes, the special resolution (and any Rule 12(4) separate resolutions) with the Rule 12(2) explanatory statement, and the MGT-14 filing proof.
• A grant letter for every mapped promise, with real grant dates, cross-referring to the assurance it settles.
• The SH-6 register, current to the last grant, vesting and lapse.
• Written settlements for every cash-closed promise, marked as full and final.
• A short board note recording why each mapping was done the way it was — the document that answers the investor's "why does her schedule differ from his?" before it is asked.

None of this guarantees a clean diligence. Facts differ, old paper differs, and a promise worded as a concluded commitment by a company that took money against it is a different animal from a hopeful line in a draft offer letter. I will not promise you an outcome on any disputed promise, and you should walk away from anyone who does. What the sequence above does give you is narrower and worth having: every promise is either inside a lawful scheme, closed by a written settlement, or consciously listed as an open item with advice taken on it. Investors can price a known list. What they walk away from is a surprise.

If your data room has an equity-promise question waiting in it — or a term sheet that just landed one on you — our ESOP services page sets out how we run the audit, the scheme adoption and the grant mapping with founders. Bring the offer letters, all of them. The clean-up starts with the full pile, not the tidy version.