Should you set up your ESOP before a funding round?

A clean and well-maintained cap table gives investors a clearer picture of who owns what and how ownership could change after the investment. The same principle applies to your ESOP. If you've already thought about your employee equity strategy, you can explain:

The ESOP pool can become part of the funding negotiation

This is one of the most important reasons founders should understand their ESOP position before entering a funding round.

Investors may want the company to have an employee option pool large enough to support the hiring needed after the investment.

For example, imagine:

• Pre-money valuation: ₹50 crore
• New investment: ₹10 crore
• Investor ownership after the round: 16.7%
• Existing ESOP pool: 4%
• Investor wants a 10% ESOP pool

The company therefore needs to increase its pool by another 6 percentage points.

The important question isn't just:

"Do we need a 10% ESOP pool?"

It is:

"How will that additional pool be created, and who bears the dilution?"

Pre-money vs post-money pool

This distinction can materially affect founder ownership.

If the additional ESOP pool is created before the investment, it is generally included in the pre-money fully diluted capitalisation. The existing shareholders therefore bear the dilution associated with creating the additional pool before the new investor's ownership is calculated.

If the pool is created after the investment, the dilution can instead be shared among the shareholders, including the new investor, depending on the agreed structure.

This is why founders should not look at the headline valuation alone.

A term sheet saying:

"₹50 crore pre-money valuation"

doesn't tell the whole story if there is also a requirement to create or top up an ESOP pool before the investment.

The fully diluted cap table and the exact treatment of the pool matter.

Scenario: the ESOP pool nobody modelled

Let's take a simplified example.

A startup has:

• Founders: 90%
• Existing employees: 10%
• No unallocated ESOP pool

The startup is raising its next round.

An investor agrees to invest at a valuation that gives them 20% of the company, but asks for a 10% ESOP pool to be available after the round.

The founders might initially think:

"We're only giving the investor 20%."

But that's not the complete ownership conversation.

The founders also need to understand what happens when the ESOP pool is created or topped up, whether it is calculated on a pre-money or post-money basis, and how the resulting fully diluted ownership looks.

That is why modelling the cap table before agreeing to the round is so important.

The same ESOP pool percentage can have a very different effect depending on when it is created and how it is treated in the financing documents.

Don't create a bigger ESOP pool just because you're fundraising

There is another side to the equation.

Creating an ESOP before a funding round can be useful, but creating an unnecessarily large pool can also create avoidable dilution.

Your ESOP should be based on your expected hiring requirements, not simply on a number suggested during fundraising.

For example, suppose you're a 30-person startup planning to hire 15 people over the next two years.

Instead of automatically creating a 15% pool because "that's what startups do", work backwards:

Which roles are you hiring?

Which roles are likely to receive equity?

What grants might those roles require?

How much of the existing pool has already been allocated?

How much additional headroom do you realistically need?

This gives you a more defensible basis for discussing the pool with investors.

There isn't a single ESOP percentage that is correct for every Indian startup.

A company hiring heavily at the leadership level may have very different equity requirements from a capital-efficient startup with a small team.

Scenario: two founders, two very different approaches

Consider two startups preparing for their first institutional round.

What happens to your ESOP after the funding round?

Creating your ESOP before a funding round doesn't mean your equity strategy ends when the round closes.

In fact, the funding round is usually when your equity administration becomes more important.

You may now have:

• New investors
• More employees
• New grants
• Different vesting schedules
• Additional share issuances
• A larger cap table
• More reporting requirements
• More stakeholders who need accurate ownership information

Your ESOP pool therefore needs to work alongside your broader cap table.

For example, an employee may receive an option grant before the Series A, continue vesting after the round and eventually exercise those options based on the terms of the scheme.

The company's ownership records need to reflect the relevant stages of that journey.

That is why it is useful to think of the ESOP as an ongoing equity programme, rather than a one-time funding-round exercise.

Don't forget the Indian tax and compliance context

For Indian employees, ESOPs also have tax implications.

Generally, when an employee exercises an ESOP and shares are allotted at a concessional price, the difference between the applicable fair market value and the amount paid by the employee is treated as a taxable perquisite. When the shares are subsequently sold, the resulting gain is generally considered under capital gains.

Eligible startups can have a tax deferral mechanism for the ESOP perquisite, subject to the applicable conditions. The Income Tax Department states that for an eligible startup, tax deduction is deferred until the earliest of specified events, including 48 months from the end of the relevant assessment year, cessation of employment or sale of the shares.

There are also corporate law requirements around issuing employee stock options. For an unlisted company covered by the relevant rules, the ESOP scheme requires shareholder approval, alongside other prescribed requirements.

This is one area where founders should work with their legal, company secretarial and tax advisers. The exact treatment can depend on the company's structure, employee eligibility, scheme terms and current regulations.

The key point for founders is simple:

Don't treat the ESOP as just a number on your cap table. The scheme itself needs to be properly structured, approved, documented and administered.

So, should you set up your ESOP before a funding round?

There is no blanket rule that says every Indian startup must create an ESOP before raising money.

But if you know you're going to hire, expect to offer equity to key employees or anticipate that investors will ask about your employee option pool, planning the ESOP before the funding round can put you in a much stronger position.

Think about it in three parts:

1. Your hiring plan

Who do you need to hire after the round?

2. Your equity plan

How much equity might you need to attract and retain those people?

3. Your funding model

How will the ESOP pool interact with your valuation, investor ownership and fully diluted cap table?

When these three pieces are considered together, you can make a more informed decision about the size and timing of your ESOP.

A practical pre-funding ESOP checklist

Before you start serious investor negotiations, make sure you can answer:

How Vestd India can help

Managing an ESOP alongside a funding round can quickly become difficult when grants, employees, documents and cap-table changes are spread across spreadsheets and disconnected records.

Vestd India brings ESOP management, cap table management and shareholder management together in one platform, giving companies a centralised view of their equity.

For a company preparing for a funding round, this can help you:

• Manage your ESOP scheme and employee grants
• Track vesting and exercise activity
• Maintain your cap table
• Model funding and ownership scenarios
• Manage employee and shareholder records
• Store and manage equity-related documents
• Handle digital document signing
• Give employees visibility into their equity
• Keep equity information organised as the company grows

The platform also supports features such as bulk ESOP and cap-table uploads, scheme generation for early-stage startups, digitally signed grant documentation, accelerated vesting, custom reporting and funding/exit modelling.

The bigger benefit is having one source of truth for your equity data as your company moves from one funding round to the next.

So, rather than asking:

"Should we create an ESOP before or after our funding round?"

the better question is: