ESOP Buyback by the Company: Mechanics & Tax

ESOPs are worthless to the average employee until two things happen — the company gets liquid, and the employee can convert vested options into cash. In India, where the median time from grant to IPO is 7-9 years, waiting for an IPO is unrealistic for most employees. The bridge structure is the company-led ESOP buyback — a tender offer by the company to repurchase a tranche of vested shares from employees, typically structured around a fundraise or a secondary round.

The buyback is governed by Section 68 of the Companies Act and taxed under Section 115QA of the Income Tax Act. Get either piece wrong and the exercise either fails NCLT approval or burns 23%+ in tax that could have been avoided. This is the practitioner’s walkthrough.

Why the buyback structure (and not just a secondary)

The alternative is a secondary sale where employees sell directly to a new or existing investor. Cleaner in some ways, but two problems — investors usually want fresh primary, not someone else’s secondary; and the company has no formal vehicle to coordinate employee liquidity at scale. The buyback solves both: the company itself becomes the buyer, the cash flows from the company’s balance sheet (often funded by the primary round), and the employee exits cleanly with no investor counterparty risk.

Section 68 — the structural constraints

A private company can buy back its own securities under Section 68 subject to the following hard limits:

Source of funds: Buy-back must be funded from (a) free reserves, (b) the securities premium account, or (c) the proceeds of any shares or specified securities — never from the proceeds of an earlier issue of the same kind of shares.

The 25% cap: The aggregate buy-back in a financial year cannot exceed 25% of the aggregate of paid-up capital and free reserves. For most startups, this is the binding constraint — a ₹100 Cr balance-sheet company can only deploy ₹25 Cr in buyback in one year.

The 25% paid-up capital cap (per buyback): Each individual buy-back cannot exceed 25% of paid-up equity capital. So even if free reserves are large, a single tranche is capped against the smaller of the two limits.

Debt-equity 2:1: Post buy-back, the secured and unsecured debt-to-paid-up-capital-plus-free-reserves ratio cannot exceed 2:1. Heavily leveraged companies sometimes fail this test and must defer the buyback.

Cooling period: No further buy-back is allowed for one year from the date of the previous buy-back. A company doing annual employee buybacks needs to time them at least 12 months apart.

The procedural steps under Rule 17

A typical Section 68 buy-back runs as follows: (1) board resolution authorising the buy-back if within 10% of paid-up capital + free reserves; otherwise, special resolution of shareholders; (2) explanatory statement with the price, number of shares, source of funds, and post-buyback debt-equity; (3) filing of Form SH-8 with the Registrar at least one day before the offer opens; (4) declaration of solvency in Form SH-9 signed by two directors; (5) offer letter sent to all eligible shareholders; (6) offer open for 15-30 days; (7) verification of acceptances within 15 days of closure; (8) payment within seven days of verification; (9) extinguishment of shares within seven days of payment; (10) Form SH-11 filed with ROC within 30 days of completion; (11) maintenance of register of buy-back in Form SH-10.

Pricing — the Rule 11UA valuation

The buyback price for unlisted shares must be supported by a merchant-banker valuation under Rule 11UA of the Income Tax Rules. Most companies use the DCF method or the NAV method depending on maturity. The price must be defensible — pricing meaningfully above the fair value can attract Section 56(2)(x) consequences for the employees (who would be deemed to have received income in excess of fair value); pricing meaningfully below frustrates the employee liquidity objective.

Around a fundraise, the practical anchor is the round price — but since secondary buybacks typically follow primary rounds, the round itself sets a defensible fair value benchmark. Most companies buy back at the round price or at a small discount (5-10%) reflecting the lack of new-investor preferences.

The 23.296% buyback tax under Section 115QA

Here is the part founders most often miss. Section 115QA imposes a buy-back tax on the company — not the shareholder — at 20% (plus surcharge plus cess, effective rate around 23.296%) on the distributed income. Distributed income is the buy-back consideration minus the issue price of the shares.

For employee ESOP shares, the issue price is the exercise price. So if the exercise price was ₹10 and the buy-back price is ₹500, distributed income per share is ₹490 — and the company pays roughly ₹114 per share as 115QA tax. On a ₹25 Cr buy-back, this is roughly ₹5.7 Cr of additional tax cost that comes out of company funds.

The shareholder receives the buy-back consideration tax-free in their hands under Section 10(34A). Net-net, the employee gets the full ₹500; the company bears the 115QA cost.

The Finance Act 2024 change — shareholder-side tax

For buy-backs effected on or after 1 October 2024, the tax incidence has been shifted from the company to the shareholder. The buy-back consideration is now taxable in the hands of the shareholder as adeemed dividend, with no deduction for the cost of acquisition (the original cost becomes a capital loss in the year of buy-back, usable against other capital gains).

This change makes the buyback structure materially less attractive for high-tax-slab employees, who now bear slab-rate tax on the entire buyback consideration rather than zero tax. Many companies have shifted post-October 2024 to capital reduction structures under Section 66 (which retain the Section 46A capital-gains treatment for shareholders) or to direct secondary sales to investors.

The capital reduction alternative

Section 66 capital reduction allows the company to reduce capital (including by extinguishing a class of shares) with NCLT approval. The shareholder treatment is capital gains, not deemed dividend — materially better tax outcome for employees post-2024. But the process is longer (NCLT approval takes 4-8 months) and more intrusive (notice to creditors, sometimes a public hearing).

For one-off large employee liquidity events, capital reduction is increasingly the preferred route post-October 2024. For small, recurring buybacks, the Section 68 route with the new tax incidence is still used, with employees pricing the tax cost into their decision to participate.

Eligibility and allocation among employees

The buyback offer must be made on a pro-rata basis to all eligible shareholders — or, where the buyback is restricted to a class (e.g., ESOP shares only), to all members of that class pro-rata. Companies sometimes structure tiered buybacks (e.g., 100% of the first 1000 vested shares, 50% of the next 4000, etc.) to weight liquidity toward smaller-balance employees. The allocation rules must be in the offer letter and applied mechanically.

Coordination with a fundraise

The classic structure: primary round closes, ₹X comes in. Of this, some portion is earmarked for employee secondary via a buyback in the immediately following quarter. The fundraise legal documents will reference the buyback intention; the buyback runs after the primary closes; the company uses the round proceeds (which by then have become free reserves) as the source of buy-back funds.

Timing matters — the buyback must complete within the financial year the round closes, or the next, to keep the source-of-funds chain clean. Investors usually impose a ceiling (e.g., “not more than 20% of round size will be used for secondary”) — model this against the Section 68 25% cap before promising employees a specific tranche.

Bottom line

ESOP buyback is the standard liquidity instrument for vested employee equity in pre-IPO Indian startups. Section 68 sets the structural envelope; Rule 11UA sets the price; Section 115QA (now shifted to the shareholder post-October 2024) sets the tax. Capital reduction under Section 66 is the increasingly preferred alternative for large one-off liquidity events. Whichever route, the buy-back is a meaningful expense — model the post-tax outcome for both the company and the employee before announcing the tranche.