Over the years, companies have used employee stock option schemes (ESOP Schemes) as an effective method to align employee interests with shareholders, reward their efforts, increase their loyalty towards the company and motivate employees to perform better.

An initial public offering (IPO) and consequent listing of equity shares is one of the critical ways in which employees seek value appreciation in stock options and equity shares held by them. Accordingly, unlisted companies typically align timing of exercise of options under ESOP Schemes with their plans to undertake an IPO.

The Securities and Exchange Board of India (Issue of Capital and Disclosure Requirements) Regulations, 2009, as amended (SEBI ICDR Regulations), which regulates IPOs, provides exceptions for ESOPs from certain eligibility conditions to be fulfilled by the issuer undertaking the IPO as well as transfer restrictions on equity shares applicable after the completion of the IPO.

However, issuers have faced challenges in the past with respect to eligibility conditions if the options have remained outstanding with individuals who have ceased to be an employee of the issuer.

Further, issuers are being increasingly questioned by such former employees, who continue to hold shares in the issuer but are not offered lock-in exemptions available to existing employees. Additional basis to these concerns is that former employees are treated beneficially under the Securities and Exchange Board of India (Share Based Employee Benefits) Regulations, 2014 (ESOP Regulations) and the Companies Act, 2013 and similar benefits have not been recognised under the SEBI ICDR Regulations.

The IPO Regime – Exemption for ESOP holders is no exception for former employees?

Eligibility conditions and treatment of former employees

The SEBI ICDR Regulations prescribe certain eligibility conditions, which every issuer is required to comply with, prior to undertaking an IPO. Regulation 26(5) of the SEBI ICDR Regulations prohibits an issuer from undertaking an IPO if there are any outstanding convertible securities or any right entitling any person with an option to receive equity shares in the issuer.

This eligibility condition has to be complied with at every stage of the IPO, whether at the filing of the draft red herring prospectus (DRHP), red herring prospectus, prospectus or undertaking allotment in the IPO. The intent of the Securities and Exchange Board of India (SEBI) behind such a broadly worded restriction appears to be to ensure that no third party continues with a right to receive equity shares of the issuer post the IPO, if such right has not been approved by the new shareholders (who have acquired shares pursuant to the IPO) as well as to maintain a level-playing field between existing shareholders and post-IPO shareholders.

However, Regulation 26(5)(b) of the SEBI ICDR Regulations also provides certain exceptions to the aforesaid restriction, including any option “granted to employees” pursuant to an employee stock option scheme can remain outstanding at the time of undertaking the IPO. In terms of Regulation 2(1)(m) of the SEBI ICDR Regulations, the definition of “employee” inter alia, includes a permanent and full-time employee of the issuer, or of the holding company or subsidiary company or of that material associate(s) of the issuer. Whilst the definition of employees has been understandably kept broad, the contour of this definition seems to be restricted to existing employees only and does not include employees of the issuer who received options during the course of their employment, but who, by the time of the IPO, have either retired or transferred to other companies within the issuer group (other than the holding company, subsidiary company or material associates, which is especially relevant in the case of large conglomerates), or have died or resigned from employment.

The critical difference between the employee who gets options and a shareholder is that the employee receives options as a reward for his performance and contribution already made by such employee to the issuer. Further, compared to other forms of options such as put/call options or options given to lenders or other third parties, ESOPs are typically distributed to a large set of employees and, hence, controlling or restricting the number and extent of such options, especially in the case of issuers with large and widespread operations, may impose a significant challenge for issuers.

If any employee of the issuer with outstanding options has ceased to be an employee at the time of undertaking the IPO for any reason, then the issuer is expected to constantly monitor such options and ensure that such unexercised options are either exercised immediately or lapsed or else, such options may directly affect eligibility of the issuer to undertake the IPO.

Lapsing of options / mandatory exercise of options

The lapsing of such vested options or requiring the former employees to mandatorily exercise them in a short period (especially when exercise involves payment) may not be in the interest of former employees especially in cases where they have ceased to be employees due to reasons such as retirement or death. Further, ensuring mandatory exercise of vested options by all former employees in a short period may not be feasible or possible for issuers (especially for issuers with a large employee base).

It could also be argued that the requirement under the SEBI ICDR Regulations is in conflict with the SEBI ESOP Regulations and the Companies Act, as the SEBI ESOP Regulations and the Companies Act allow former employees to hold vested options granted to them during the course of employment till the exercise is called for by companies under the relevant ESOP Scheme.

Exemption from Strict Interpretation of Regulation 26(5)(b)

Owing to such practical difficulties, in the past, issuers have approached SEBI seeking exemption from a strict interpretation of Regulation 26(5)(b) of the SEBI ICDR Regulations to include former employees of the issuers. Issuers have sought exemptions to enable former employees of issuers to hold the stock options prior and post listing of the equity shares. Certain grounds for seeking such exemption include (i) that the stock options were issued to the former employees, while they were in the employment of the issuer, its holding or subsidiary companies; (ii) it would not be in the interest of such former employees to lapse the stock options granted and/or vested in such former employees; (iii) it would not be practically feasible to the issuer to stall the IPO until it reaches out to all such former employees, especially when exercise of options is dependant on completion of the IPO; and (iv) the issuer intends to reward the former employees as an appreciation for being associated with the issuer and for their efforts. Whilst SEBI has been sensitive to such circumstances and has provided exemption, a discussion with respect to this provision of the ICDR Regulations is necessary.

Lock-in of Equity Shares on Allotment in an IPO

Regulation 37 of the SEBI ICDR Regulations provides that the entire pre-issue capital held by persons shall be locked-in for a period of one year from the date of allotment in the IPO. Whilst Regulation 37 provides an exception from the provisions of lock-in of the equity shares to the employees of the issuer who have been allotted the equity shares under the employee stock option plan of the issuer, this exemption is also applicable only for existing employees and does not extend to former employees. SEBI has clarified this position in its informal guidance issued to Firstsource Solutions Limited and Multi Commodity Exchange of India Limited.

Whilst it is understandable that the lock-in exemption is not available for employees who have voluntarily resigned, or been removed, from employment , it could be considered unfair for the lock-in exemption to not be available to employees who received options and subsequently, retired or died or are permanently incapacitated. Such individuals deservedly received such options and have complied with all requirements of their respective schemes.


In view of the above discussion and given that issuers and former employees face various challenges during the process of IPOs by issuers, it could be suggested that the SEBI ICDR Regulations and the ESOP Regulations should be reconciled to include resigned, retired, transferred employees and nominees of deceased employees within the ambit of “employees”. Further, the exemption from lock-in of equity shares should also extend to former employees who have acquired equity shares under the ESOP Scheme during the course of employment and whose employment has ceased due to retirement, death or permanent incapacity. These changes will have the following potential benefits:

  1. Former employees will benefit and not be forced to exercise before various stages of the IPO and also be able to sell the equity shares post listing without lock–in.
  2. Enable issuers to vest and allow exercise of stock options closer to listing (as compared to DRHP) which may help in avoiding creation of a large grey market for equity shares of the issuer.
  3. The benefit of listing gains could also be enjoyed by former employees who received options due to their employment.
  4. Most importantly, issuers will not breach eligibility conditions for undertaking an IPO.

* The authors were assisted by Neha Samant, Associate