Lawsikho Blog

Learn how to identify red flags in ESOP documentation, validate compliance, and prepare clean reports during investor or acquisition due diligence. This guide assumes a private limited company structure, common for Indian startups. Additional considerations may apply for public or listed companies.

Introduction

I felt my heart race when my friend told me how her client lost their big funding chance overnight. Why? Just because of some problems with their employee stock options (ESOPs).

While sipping coffee at Bistro 21 in Connaught Place, she explained that the investors’ lawyers found several issues with the ESOP: 

• there was no board resolution approving the ESOP scheme. 
• outdated ESOP records, and 
• missing grant letters that should have gone to employees. 

Listening to her, I thought, “Wow, that could have happened to me, too!“

Nevertheless, if you have been following my series on ESOPs, you must already be familiar with our journey through the complete ESOP lifecycle. 

For new readers, let me provide a quick overview of what I have covered so far:

In [How to draft an ESOP scheme (Part 1)], I introduced TechSolve, a B2B SaaS startup with three co-founders—Vikram, Priya, and Arjun—who needed to implement an ESOP to attract key talent while managing cash constraints. I covered the foundational elements of their ESOP scheme: 

• crafting a purpose clause that aligns incentives, 
• defining terms to prevent misunderstandings, 
• establishing clear eligibility criteria, and 
• determining the optimal pool size (9% of their equity) for their growth stage.

In [How to draft an ESOP scheme (Part 2)], I built upon this foundation and explored the operational mechanics: 

• how options are granted, 
• when they vest, 
• how employees exercise them, 
• what happens when people leave, and 
• how disputes get resolved. 

We created a comprehensive framework that balanced TechSolve’s needs with employee-friendly provisions.

With the ESOP document drafted, [How to approve an ESOP scheme] walked through the step-by-step legal process for properly implementing the scheme from board approval through shareholder consent to required regulatory filings with the ROC, ensuring TechSolve’s ESOP would stand up to legal scrutiny.

Most recently, in [How to draft an ESOP grant letter], I crafted a compelling grant letter for Aanya Sharma, TechSolve’s prospective CTO, showing how to clearly communicate equity offers to senior hires in a way that builds trust and closes deals.

Now, we have reached the final piece of the puzzle, i.e., due diligence. 

While the previous articles focused on creating a robust ESOP program, this article addresses what happens when the ESOP documentation faces external scrutiny during funding rounds or acquisitions.

For this purpose, let us revisit TechSolve and imagine they are now preparing for their Series A funding round. 

Understanding the scope of ESOP due diligence

Before diving into document reviews, you need to understand exactly when ESOP due diligence happens and what it aims to accomplish.

For TechSolve—now two years into operations with their ESOP scheme implemented and preparing for their Series A funding—this due diligence process will be crucial. Their prospective investors would want assurance that the 9% ESOP pool they have created is properly documented, legally sound, and would not create unexpected liabilities for the investors post-investment.

When ESOP Due Diligence happens:

• During funding rounds (particularly Series A and beyond), as TechSolve is experiencing now
• During mergers and acquisitions, when acquirers need to understand exactly what equity commitments they’re assuming
• As part of internal audits and compliance reviews, proactive companies conduct these periodically to identify and fix issues before external scrutiny

Key questions Due Diligence answers:

• Is the ESOP valid and properly approved? This verifies whether TechSolve followed all legal requirements under section 62(1)(b) of the Companies Act and filed necessary forms with the ROC.
• Are individual grants documented and compliant? This confirms whether those grant letters to employees (like Aanya Sharma’s CTO offer) were properly authorised and tracked.
• What is the actual and potential dilution from the ESOP? This helps investors understand not just the current dilution from issued grants but also potential future dilution if the entire pool is utilised.
• Are there any legal or tax pitfalls that could create future liabilities? This identifies whether TechSolve has exposed itself or its employees to unnecessary tax burdens or regulatory risks.

Why does this matter for TechSolve?

For TechSolve specifically, their 9% ESOP pool represents significant equity value. With their anticipated pre-Series A valuation of ₹40 crore, that is approximately ₹3.6 crore of value set aside for employees. Investors want to be certain this value is being properly managed.

Additionally, since TechSolve has likely already made several key grants to their CTO, Aanya Sharma, and potentially other senior hires, ensuring these grants were properly documented prevents potential disputes that could distract from building the business.

Step-by-Step: Reviewing the ESOP like a pro

For this section, I want you to imagine that you are a lawyer representing a venture capital firm that is considering investing ₹20 crore in TechSolve. 

The investor is excited about the company’s product and growth trajectory, but before wiring the funds, they need you to verify that the ESOP situation is clean. The partner has given you just three days to review everything and report back.

Where do you start? What documents should you request? How do you identify real problems versus minor administrative oversights?

Do not worry, I will break down the ESOP review process into clear, sequential steps any lawyer can follow, regardless of experience level. 

For each step, I will explain what to look for, what to flag, and how to work effectively when information is incomplete—because trust me, something will always be missing.

Step 1: Check scheme approval and ROC compliance

This should always be your starting point because if the ESOP scheme itself is not properly approved, every grant issued under it could be problematic.

The first document you should ask for while reviewing TechSolve’s documents is evidence that the ESOP scheme was properly approved. As an investor’s lawyer, these are the documents you should request:

Look for:

• board resolution approving the ESOP scheme
• special resolution of shareholders under section 62(1)(b) of the Companies Act
• MGT-14 filing with the Registrar of Companies within 30 days of the special resolution

Do not just confirm these documents exist, but cross-reference them to make sure they are consistent. When I review a board resolution, I check if it specifically references section 62(1)(b) and explicitly authorises the creation of the ESOP pool with a specific size. Then I verify that the shareholders’ resolution matches that authorisation.

Flag this: No MGT-14 filing is a major red flag. Without this filing, the scheme may be unenforceable, and rectifying this could require fresh approvals and potentially complex ratification processes.

What to do if documentation is incomplete: If MGT-14 is missing, check if the 30-day filing window is still open. If not, the company may need to conduct a fresh approval process, or the company may need to apply to the Central Government for condonation of delay under section 460 of the Companies Act, 2013 (e-form CG-1), as the ROC does not directly handle such requests.

Either way, flag this as a critical issue that needs resolution before closing.

I once discovered a startup had submitted its MGT-14, but it was rejected by the ROC due to technical reasons, and the company never resubmitted it—a fact they themselves were not aware of until our diligence. The investment was delayed by three weeks while they fixed this issue.

Step 2: Review the ESOP scheme document

Once you have confirmed proper approval, examine the substance of the scheme itself.

When reviewing an ESOP document, you need to make sure it’s not just legally valid but also practically sound and aligned with market standards.

Look for:

• Pool size (both number of options and percentage of equity)
• Vesting terms (typical is 4 years with a 1-year cliff)
• Buyback provisions and mechanics
• review tax treatment clauses, noting that ESOP taxation in India (under the Income Tax Act, 1961) varies based on factors like the type of ESOP and employee tax brackets. Recommend consulting a chartered accountant or tax specialist for compliance.
• Termination scenarios (good leaver/bad leaver provisions)

When reviewing the ESOP document, read it like both a lawyer and an employee. I often ask myself: “If I were granted options under this scheme, what questions would I have?” This helps identify ambiguities and potential disputes.

Flag this: Missing buyback clauses or no clarity on what happens to options when employees leave the company are particular red flags. These gaps often lead to disputes when employees exit or when liquidity events approach.

When reviewing an ESOP scheme like TechSolve’s, you might find termination provisions that aren’t clear about what happens to vested options if an employee is terminated without cause. This type of ambiguity could create disputes down the road.

Real-world fix: If you identify problematic language, suggest adopting standard clause formats and flag any tax ambiguity for specialist review. For one client, I discovered their termination provisions were unintentionally harsh (employees lost vested options if they resigned), which was causing retention issues. I recommended board approval of a clarifying amendment.

Step 3: Match grants to resolutions

This step verifies that individual option grants were properly authorised and documented.

When reviewing a company’s grant process, you need to ensure that every option granted to every employee has proper authorisation and documentation.

Look for:

• grant letters issued to employees
• board or committee resolutions approving each grant or batch of grants
• dates of grants matching the dates of board/committee approvals
• consistency between the number of options granted and the available pool size

The critical skill here is meticulously tracking numbers. 

You can create a simple spreadsheet showing the total ESOP pool size, each grant with date and number of options, and a running calculation of options remaining in the pool. This helps identify any over-allocation or record-keeping errors.

Flag this: Grants made before scheme approval or grants issued without board/committee ratification are serious red flags that could invalidate the options.

I once reviewed a startup where the HR team had been issuing grant letters with the CEO’s approval but without formal board resolutions. This meant that nearly 30% of their ESOP grants lacked proper authorisation. We had to organise an emergency board meeting to ratify these grants before the investment could proceed.

Coordination tip: Request grant records from HR early in the process. Use a tracker to follow up if documents are pending. In my experience, grant letters are among the most commonly misplaced documents, particularly for early employees who may have received options before formal processes were established.

Step 4: Verify the ESOP register and Cap Table

This step confirms that the ongoing administration of the ESOP has been proper and consistent.

For any company under review, you need to verify they have maintained proper records of all ESOP activity—from initial grants through vesting milestones to any exercises or cancellations.

Look for:

• ESOP register maintained in Form SH-6
• Accuracy of entries (vesting events, exercises, and lapses)
• Alignment with the most recent cap table

I always check if the ESOP register reflects not just grants but also vesting milestones, exits, and exercises. A properly maintained register should tell the complete story of each option grant from issuance to ultimate disposition.

Flag this: No register maintained is a major red flag. I have seen cases where the absence of a proper register made it impossible to determine with certainty who owned what percentage of a company, delaying a funding round by weeks.

When examining a company’s register, you might find they have not been updating it to reflect vesting milestones—only initial grants and exercises. This is a common oversight to watch for. 

This meant they could not easily tell which employees had vested options and which were still in their cliff period.

Coordination tip: Ask finance for the most recent cap table and reconcile with register entries. Note and report all mismatches. I typically request cap tables in editable format so I can add my own analysis columns to identify and quantify discrepancies.

Step 5: Analyse dilution and valuation

This step looks at the bigger picture of how the ESOP affects overall company ownership.

For TechSolve and its investor, understanding the true dilutive impact of the ESOP is crucial for accurate valuation.

Look for:

• total pool vs. granted options vs. unallocated options
• whether the ESOP pool is calculated on a pre-money or post-money basis, as this determines how dilution is shared between existing shareholders and new investors. Pre-money pools dilute all shareholders equally, while post-money pools shift more dilution to pre-investment shareholders
• Ensure an updated Fair Market Value (FMV) certificate, determined by a registered valuer as required under Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014, for unlisted companies. An outdated FMV can lead to tax penalties

When analysing dilution, I always prepare two versions: current dilution (based on issued grants) and potential dilution (if the entire pool is utilised). Investors will want to understand both scenarios.

Flag this: Using outdated FMV or hiding unallocated pool from pitch materials are concerns that should be highlighted. These practices might suggest either negligence or intentional misrepresentation of dilution.

You might discover discrepancies between what is presented in investor materials and what is formally approved. For example, a company might mention a ‘9% ESOP pool’ in their pitch deck, but may have only formally created and approved an 8% pool. 

The additional 1% was planned but not yet approved. This discrepancy needed to be addressed before closing.

How to draft a clear ESOP review note

After completing your review, you need to communicate your findings effectively. 

Your due diligence memo is a risk assessment tool that will help investors make informed decisions.

When I deliver ESOP due diligence findings, I make sure to prepare a concise 1-page summary followed by detailed appendices. It has worked best for most clients and investors. It respects their time while giving them the depth they need if they want to dig deeper.

Here is a structure you can follow for an effective ESOP review note:

Section 1: Status summary

Start with a high-level assessment that a busy partner or investor can digest in 30 seconds:

• approval status of the ESOP scheme
• total pool size and current utilisation
• register and documentation completeness assessment
• overall compliance rating (I recommend using a simple Green/Yellow/Red system)
• Use a Green/Yellow/Red system where: Green indicates full compliance with no issues; Yellow signals minor issues needing attention but not critical; Red denotes serious issues requiring immediate resolution before closing.

For example, your summary might read: “TechSolve’s ESOP scheme is properly approved (Green), with 8% of the 9% pool utilised (Yellow), and documentation is 90% complete with minor gaps in historical grant letters (Yellow). Overall compliance rating: Yellow – requires attention but no critical issues.”

Section 2: Key risks

This section focuses on substantive issues rather than document management:

• legal gaps or approval issues
• documentation inconsistencies or missing records
• valuation or tax compliance concerns

Be specific about each risk. Rather than saying “Some grant letters are missing,” say “Grant letters for 3 employees who joined in 2023 are missing, representing 0.5% of total equity.”

Section 3: Actionables

Transform your findings into practical next steps:

• immediate fixes required before transaction closing
• medium-term improvements recommended
• potential liability quantification (where possible)

For example: “Before closing, company must: (1) locate missing grant letters or issue confirmation letters; (2) update ESOP register to reflect recent vesting events; (3) reconcile the discrepancy between the 8% approved pool and 9% referenced in investor materials.”

The key to an effective ESOP review note is prioritisation. Distinguish between “deal-breakers” that must be addressed before closing and “housekeeping issues” that can be remedied post-transaction. This practical approach prevents minor issues from unnecessarily derailing deals.

When reviewing a client whose ESOP documentation initially revealed 14 issues, you might categorise them into “critical” (3 issues), “important” (5 issues), and “administrative” (6 issues). This creates a manageable roadmap that satisfies investors without overwhelming the company.

I have attached a review note here for your reference.

Common red flags and what to do about them

Based on my experience reviewing dozens of ESOP schemes, here are the most common problems I encounter and practical solutions to recommend:

Red flag	Why is a problem	What you can recommend
Grants issued before approval	Options may be unenforceable	Ratify via board resolution and EGM; file MGT-14
No buyback clause	Employees have no liquidity path	Amend the scheme with shareholder approval via a special resolution, and obtain investor consent if required by investment agreements.
Outdated FMV	Tax mismatch during exercise	Get a fresh valuation certificate before allowing exercises
No SH-6 register	MCA non-compliance	Prepare the register retrospectively using grant letters and board minutes
Missing grant letters	No enforceable record of the grant	Reissue letters with acknowledgment of the original grant date, ensuring terms remain consistent with the original grant. Consult a tax advisor to avoid adverse tax consequences for employees or the company.

Remember that the goal of flagging these issues is not to derail deals but to identify practical solutions. I always provide template language or process recommendations alongside my findings.

For instance, when I identified missing grant letters for early employees at one startup, I provided a template “confirmation letter” that acknowledged the original grant date while creating a contemporaneous record. This satisfied the investor’s concerns while protecting employee rights.

Final thoughts

With this article, I have completed our comprehensive ESOP journey together.

From drafting the foundational clauses in Part 1 to operational mechanics in Part 2, implementing the scheme, creating grant letters, and now conducting due diligence. I am sure you must have gained end-to-end expertise in managing ESOPs for Indian startups.

Lawyers who master this niche would become invaluable during transactions and would know how to safeguard equity promises made to the people who built the company.

Always remember that a due diligence exercise should not be limited to merely identifying problems—it should also focus on finding solutions to issues that could derail the transaction. That’s what separates good lawyers from great advisors.

If you get a chance to review an ESOP scheme, approach it with the thoroughness and care it deserves. Your attention to detail today prevents disputes tomorrow, creating equity programs that truly work for everyone involved.

Best of luck with your ESOP project—I hope these articles serve as your trusted guide.