Introduction
The Securities and Exchange Board of India (SEBI) recently released a consultation paper proposing amendments to the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 (ICDR Regulations) and the SEBI (Share Based Employee Benefits and Sweat Equity) Regulations, 2021 (SBEB Regulations). These amendments aim to streamline public issue processes and remove ambiguities in regulatory provisions. Interestingly, the two primary areas of proposed changes involve (1) the minimum holding period for equity shares to be eligible for an Offer for Sale (OFS) in a public issue and (2) clarification on Employee Stock Option Plans (ESOPs) granted to founders classified as promoters at the time of filing the Draft Red Herring Prospectus (DRHP).
The author argues, firstly, that SEBI’s proposed clarification on the minimum holding period for equity shares arising from the conversion of compulsorily convertible securities under approved schemes is a welcome move, as it removes regulatory ambiguity and aligns with the principle of consistency across the ICDR framework. However, the article notes that unless OFS eligibility is explicitly extended to such conversions, regulatory gaps will persist, potentially discouraging legitimate restructuring. Secondly, the author turns to the issue of ESOP eligibility for startup founders transitioning into promoters, arguing that while SEBI’s move to protect pre-IPO ESOPs is commendable, it inadequately addresses the need for structured post-listing equity incentives. The continued prohibition on fresh ESOPs for promoters of listed New Age Technology Companies (NATCs) is portrayed as a disincentive for long-term founder involvement. The article also critiques the ambiguous one-year look-back provision, highlighting how its lack of clarity could lead to interpretational disputes and delay IPOs, as evidenced by the NSE case. Ultimately, the author suggests that while the reforms align Indian regulations with global practices, SEBI must go further by allowing post-listing ESOPs for founders, resolving timeline ambiguities, and enhancing transparency through robust disclosure norms
Convertible Confusion of Minimum Holding Period for Equity Shares in an OFS
Under Regulation 8 of the ICDR Regulations, equity shares can only be offered for sale to the public if they have been held by the sellers for at least one year prior to filing the draft offer document. However, an exemption, under Regulation 10(1)(d)(ii) of the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011, exists for shares acquired under court or tribunal approved schemes in lieu of business and invested capital that has existed for over a year. Collectively, the current framework does not explicitly extend this exemption to shares arising from the conversion of fully paid-up compulsorily convertible securities obtained through such approved schemes.
This regulatory gap creates uncertainty regarding the eligibility of these converted equity shares for an OFS. SEBI’s consultation paper suggests amending Regulation 8 to explicitly include equity shares obtained from the conversion of compulsorily convertible securities acquired through approved schemes. This amendment would align OFS eligibility criteria with the minimum promoter contribution (MPC) requirement under Regulation 15 of the ICDR Regulations (Regulation 15), which already extends such an exemption to specified securities.
From a regulatory standpoint, the one-year holding period ensures that shareholders demonstrate long-term commitment before offering their shares to the public. However, if the underlying capital investment predates the scheme’s approval, the conversion of securities into equity shares should not create an artificial restriction on OFS eligibility. Prima facie, the proposed amendment logically extends the existing exemption, fostering consistency between different regulations.
Clarification on ESOPs for Promoter-Founders: Is it Enough?
In startup ecosystems and emerging businesses, founders often hold substantial stakes while playing executive roles akin to employees. Under Regulation 9(6) of SBEB Regulations, ESOPs are typically reserved for employees and non-promoter directors, while individuals holding more than 10% of a company’s equity, either personally or through affiliated entities, are generally excluded from such schemes to mitigate conflicts of interest and safeguard minority shareholder rights. If such founders are initially granted ESOPs before filing the DRHP and are later classified as promoters, ambiguity arises regarding the treatment of these ESOPs under the existing framework.
The current regulatory framework does not explicitly address whether ESOPs granted before the DRHP filing should be subject to the restrictions applicable to promoters. The consultation paper proposes clarifying that ESOPs granted prior to the DRHP filing should remain eligible, provided they were granted when the founders were not classified as promoters.
ESOP Fables: When Founders Become Promoters
The rationale behind excluding promoters from ESOP schemes is to prevent undue benefits accruing to controlling shareholders at the expense of minority investors. However, in the case of startup founders who transition into promoters post-DRHP, ESOP grants reflect past contributions rather than preferential treatment. The proposed clarification acknowledges this distinction and ensures that regulatory constraints do not inadvertently penalize founders who contribute significantly to business growth before a public offering.
A pertinent example illustrating the regulatory challenges surrounding Employee Stock Option Plans (ESOPs) for startup founders transitioning into promoters is the case of Healthvista India, the parent company of Portea Medical. In July 2022, Healthvista filed its Draft Red Herring Prospectus (DRHP) with the Securities and Exchange Board of India (SEBI) for an initial public offering (IPO). Initially, the company stated that it did not have identifiable promoters. However, following SEBI’s intervention, Healthvista reclassified its founders as promoters in March 2023 to comply with regulatory requirements.
This reclassification underscores the complexities faced by startup founders who, despite their significant contributions and initial non-promoter status, are later designated as promoters during the IPO process. Such transitions can impact the applicability and benefits of ESOPs, as existing regulations often restrict promoters from participating in these schemes. To address this issue, SEBI has proposed amendments to allow founders to retain and exercise ESOPs granted prior to the IPO, acknowledging their past contributions and ensuring they are not unfairly disadvantaged due to their reclassification as promoters.
Founders, ESOPs, and Regulatory Enigma
Under Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014, unlisted companies are restricted from granting ESOPs to promoters or promoter group members, with an exception carved out for startups under the Department for Promotion of Industry and Internal Trade (DPIIT) framework for up to ten years. This exemption has allowed several NATCs to issue ESOPs to their founders, circumventing the promoter restriction by arguing that, at the time of the grant, the recipients were not technically “promoters.” However, once these companies transition towards a public listing, founders with substantial equity holdings are often mandatorily identified as promoters under SEBI’s IPO framework, bringing them under the purview of SEBI’s ESOP restrictions. Inferentially, the transition creates an arbitrary regulatory barrier as ESOPs granted lawfully to founders pre-IPO suddenly become uncertain post-IPO due to the founders’ reclassification.
Clause 3.3 of SEBI’s proposed amendment seeks to address this regulatory inconsistency by allowing founders who were granted ESOPs before the IPO decision to retain and exercise them even after being designated as promoters. However, question arises whether this would establish a clear regulatory standard or introduce further subjectivity by limiting the eligibility window to one year before the IPO decision.
Regulatory Gaps to Fresh ESOPs
While the proposal provides much-needed clarity on the permissibility of pre-existing ESOPs, it fails to extend the same logic to fresh ESOP grants for promoters of listed companies. This rigid stance discourages long-term alignment between founders and their companies post-listing. If the regulator is serious about fostering a vibrant startup ecosystem, why should founders of listed NATCs be denied a mechanism that encourages their continued involvement in the company’s growth?
Interestingly, the Consultation Paper’s one-year look-back provision lacks specificity. It is unclear whether the one-year period should be calculated from the date of a board resolution approving fund-raising in principle, the final IPO approval resolution, or the actual DRHP filing. This lack of clarity creates room for interpretational disputes, particularly in cases, where IPO approvals face delays due to market conditions or regulatory holdups. The National Stock Exchange of India’s (NSE) initial public offering (IPO) process exemplifies how regulatory ambiguities can lead to interpretational disputes and delays. In December 2016, NSE filed its Draft Red Herring Prospectus (DRHP) proposing a public issue of 11.14 crore shares. However, the process faced delays due to regulatory challenges, particularly concerning allegations related to its algorithmic trading platform. In August 2024, NSE reapplied for a “no-objection” certificate from the Securities and Exchange Board of India (SEBI) to proceed with its IPO. Subsequently, in October 2024, NSE settled a significant case by paying ₹643 crores, addressing concerns related to its trading access point system.
Investors, seeking to expedite the IPO process, filed a petition in the Delhi High Court requesting SEBI’s approval for NSE’s listing. SEBI resisted the petition, questioning the forum’s standing and citing unresolved issues from the co-location controversy as reasons for withholding permission. A more precise regulatory approach would be to fix the eligibility period from the date of DRHP filing, ensuring uniform application across companies.
SEBI’s Regulatory Echo: Humming the SEC & FCA Tune
Notably, The U.S. Securities and Exchange Commission (SEC) allows ESOPs granted before a public listing to remain valid, provided they are adequately disclosed. Similarly, the UK’s Financial Conduct Authority (FCA) regulations do not impose rigid restrictions on the sale of equity shares derived from converted securities if the investment predates the restructuring event. These jurisdictions, while ensuring transparency and fairness, refrain from overregulating bona fide pre-listing arrangements. Similarly, SEBI continues to entertain disproportionate limitations in such cases not only places its regulatory regime at odds with SEC and FCA, but also risks discouraging legitimate early-stage investment and employee incentivization.
Conclusion
SEBI’s proposed amendments reflect a commendable intent to harmonize India’s capital markets framework with commercial realities. However, the consultation paper’s incrementalism demands sharper doctrinal clarity and operational precision. The proposed inclusion of equity shares arising from compulsorily convertible securities, acquired under court/tribunal-sanctioned schemes, within the ambit of Regulation 8 of the ICDR Regulations is necessary but insufficient. SEBI can explicitly extend the OFS eligibility exemption under Regulation 10(1)(d)(ii) of the SAST Regulations to cover such conversions, provided the underlying capital has been invested for over one year. This would align OFS norms with the MPC exemption under Regulation 15 and eliminate interpretational uncertainty stemming from divergent treatment of identical transactions.
Secondly, the retention of pre-DRHP ESOPs by founders transitioning into promoters is a rational corrective to the legal vacuum. Yet, SEBI’s proposal remains encumbered by an arbitrary one-year look-back period, which lacks definitional clarity. Anchoring the eligibility period to the DRHP filing date would provide certainty and insulate legitimate ESOPs from disqualification during long IPO timelines.
Thirdly, SEBI’s blanket prohibition on fresh post-listing ESOPs for promoters creates an unjustified disincentive for NATCs. A conditional carve-out, subject to a 10% cap, cooling-off period, or shareholder approval, would balance founder incentives with investor safeguards.
This blog is written by Tejas Chandna, Yashashvi Sharma, 4th Year student, Symbiosis Law School, Pune
