Structuring ESOPs for the Operational Team of a Venture Capital Fund

Posted On - 6 August, 2025 • By - Rohitaashv Sinha

Employee Stock Option Plans (ESOPs) are a cornerstone of modern compensation strategies, providing employees with a stake in the success of the organization they serve. While ESOPs are most commonly associated with startups and technology firms, venture capital (VC) funds are increasingly recognizing their value—particularly when it comes to incentivizing and retaining operational team members who play a crucial role in ensuring smooth fund operations.

Why Offer ESOPs to the Operational Team of a VC Fund?

The operational team of a VC fund includes finance controllers, compliance officers, investor relations specialists, fund administrators, analysts, and legal professionals. Unlike the General Partners (GPs) or Limited Partners (LPs) who enjoy a direct share in the fund’s returns, these team members are often compensated through fixed salaries and annual bonuses. However, given their critical role in managing fund activities, an ESOP plan can align their incentives with the overall success of the fund.

Key reasons for introducing ESOPs for operational teams include:

  • Retention of Talent: ESOPs create long-term financial incentives, reducing employee attrition.
  • Alignment with Fund Performance: By linking benefits to the fund’s performance metrics, employees remain focused on improving operational efficiency and fund outcomes.
  • Cost-Effective Compensation: ESOPs can supplement or partially replace cash bonuses, conserving liquidity while offering competitive compensation.
  • Cultural Shift: A sense of ownership boosts employee morale and fosters a performance-driven environment.

Preliminary Considerations for Designing ESOPs

Before creating an ESOP structure, VC funds must address several strategic and legal considerations:

a) Entity Structure

  • The first step is understanding the legal form of the fund and its management company.
  • Is the fund organized as an LLP, trust, or corporate structure?
  • Which entity will issue the ESOP? Typically, ESOPs are issued by the management company (AMC) that receives management fees or carries, rather than the fund itself.

b) Jurisdictional and Regulatory Framework

  • Funds often have cross-border structures, with entities domiciled in jurisdictions such as Mauritius, Cayman Islands, or Singapore. Local corporate laws, tax rules, and securities regulations must be reviewed to ensure ESOP compliance.

c) Valuation

  • Determining the value of the AMC or its carried interest is essential. Independent valuations ensure fairness and compliance with regulatory requirements, particularly in India under Rule 11UA of the Income Tax Rules.

d) Taxation

  • Both the fund and employees must understand the tax implications of grants, vesting, and exercise. In India, ESOP benefits are taxed as perquisite income at exercise, followed by capital gains tax on sale. Phantom equity structures are treated as salary income upon payout.

e) Eligibility

  • Not every employee needs to be part of the ESOP pool. Generally, key operational personnel—such as the CFO, COO, fund controllers, legal and compliance heads, and senior analysts—are prioritized.

Approaches to Structuring ESOPs

Designing ESOPs for operational teams requires flexibility and alignment with the fund’s unique economics. The following structures are commonly used:

A. Phantom Equity or Shadow Stock Plans

  1. Phantom equity grants employees the economic benefits of share ownership—such as a percentage of profit or valuation growth—without transferring actual equity.
  2. How it works: Employees receive “units” that mirror the value of shares in the AMC or carried interest pool. Upon a liquidity event (e.g., carried interest distribution or sale of AMC stake), the phantom units are settled in cash.

Pros:

  • Avoids equity dilution and complex cap tables.
  • Flexible and customizable to performance metrics.
  • Works well across multiple jurisdictions.

 Cons:

  • Cash outflows must be planned during liquidity events.
  • Requires strong contractual agreements for enforceability.

Best Use Case:

  • Mid-to-senior operational team members who contribute to fund performance but don’t require voting rights.

B. Carve-Out Carry ESOPs

  • Operational employees receive a share of the fund’s carried interest, typically through a dedicated pool carved out by the GPs.
  • How it works: A fixed percentage of the total carry (e.g., 2%-5%) is allocated to the “Ops ESOP Pool.” Units are granted to employees and vest over time. Payouts are made once carry distributions occur (generally post-exit events).

Pros:

  • Directly links rewards to fund performance.
  • No ownership in the AMC, simplifying governance.

Cons:

  • Requires alignment with LP agreements.
  • Vesting benefits are realized only at fund liquidation, which can take 8–10 years.

Best Use Case:

  • Funds seeking to tie operational staff rewards directly to the success of portfolio exits.

 C. Direct Equity in the Management Company

  • Employees receive actual shares in the AMC or GP entity.
  •  How it works: ESOPs are issued in line with the Companies Act, 2013 (in India) or equivalent corporate law. Employees exercise their options to become minority shareholders.

Pros:

  • Offers real ownership and dividends.
  • High motivation due to genuine equity participation.

Cons:

  • Complicates governance and shareholder agreements.
  • Not ideal for junior employees.

Best Use Case:

  • Senior leadership roles (CFO, COO, Head of Legal).

D. ESOP Trust Structure

  • For funds managed by private limited companies, ESOP trusts can be established to administer and buy back shares for employees.
  • Allows smooth liquidity and buyback mechanisms.
  • Must adhere to SEBI ESOP Regulations (if applicable) or company-specific rules.

Steps to Design an Effective ESOP Plan

A well-crafted ESOP requires careful planning and documentation. The process involves:

  • Step 1: Create the ESOP Pool – Determine the size of the pool—usually 5%-10% of the AMC’s equity or carry. Consider long-term hiring needs.
  • Step 2: Draft the ESOP Scheme – The scheme document should include eligibility criteria, vesting schedules (e.g., 4 years with a 1-year cliff), exercise price (based on FMV), liquidity provisions, and forfeiture rules (e.g., resignation, termination for cause)
  • Step 3: Obtain Approvals – In India, board and shareholder approvals are mandatory for issuing ESOPs. The Articles of Association may need amendments.
  • Step 4: Determine Vesting Conditions- Performance-linked vesting (e.g., fund IRR thresholds) can be used in addition to time-based vesting.
  • Step 5: Valuation and Tax Planning – Engage a registered valuer to determine the fair market value of shares/options. Evaluate tax structuring, such as deferring exercise until liquidity events.
  • Step 6: Draft Grant Letters – Each employee should receive a grant letter detailing the number of options, vesting schedule, and exercise price.
  • Step 7: Establish Liquidity Mechanisms – Funds can plan liquidity events through AMC buybacks, third-party sales, or cash-settled phantom plans.

Tax Implications of ESOPs

 For Employees:

  • At Grant: No tax.
  • At Vesting: Still no tax.
  • At Exercise: The difference between FMV and exercise price is taxable as a perquisite.
  • At Sale: Capital gains tax applies on sale of shares.

For Phantom Equity Plans:

  • Taxed as salary income upon payout.
  • No capital gains tax since no actual shares are involved.

For the AMC / Fund:

  • ESOP-related expenses (discount on issue) can be claimed as a deduction under Section 37 of the Income Tax Act.
  • TDS obligations arise when employees exercise or receive payouts.
  1. ESOP Scheme Document – Master framework approved by the board.
  2. Grant Letters – Detailing employee-specific terms.
  3. Board and Shareholder Resolutions – Authorizing ESOP pools and grants.
  4. Valuation Certificates – Ensuring compliance with tax laws.
  5. Trust Deeds (if applicable) – For ESOP trust-based structures.  

For cross-border funds, FEMA and RBI regulations (in case of foreign employees) must also be reviewed.

Best Practices for ESOPs in VC Funds

  • Link ESOPs to Fund Performance: Combine time-based vesting with performance triggers such as fund IRR or MOIC (Multiple on Invested Capital).
  • Communicate Clearly: Explain ESOP mechanics to employees to avoid misunderstandings.
  • Offer Liquidity Windows: Plan periodic buybacks or cash settlements, especially in phantom plans.
  • Review Annually: Update the pool size and terms to reflect changes in fund structure or market dynamics.
  • Avoid Over-Complexity: Simplicity ensures better understanding and execution.

Case Study – Mid-Sized Indian VC Fund

A mid-sized VC fund with a ₹1,000 crore corpus implemented a carve-out carry ESOP for its operations team:

  • Pool Size: 2.5% of total carried interest (across all portfolio exits).
  • Participants: 8 senior employees, including compliance, finance, and investor relations staff.
  • Vesting: 4 years with annual graded vesting.
  • Trigger: Payout linked to successful exits and carry distributions above a 15% IRR benchmark.
  • Structure: Phantom units, avoiding any equity dilution.

 The result? Increased retention, enhanced fund compliance, and improved alignment with long-term goals.

Challenges and Mitigation Strategies

  • Challenge 1: Long Fund Cycles – Operational teams may not see payouts for years.
    Solution: Introduce partial vesting bonuses or phantom cash-outs at interim milestones.
  • Challenge 2: Valuation Complexities – Determining AMC value can be difficult.
    Solution: Use a hybrid valuation approach based on management fee revenue and projected carry.
  • Challenge 3: Tax Burden at Exercise – Employees may struggle with tax payments when exercising options.
    Solution: Defer exercise to liquidity events or offer cash-settled phantom plans.

Conclusion

As venture capital funds grow in size and complexity, retaining top operational talent is no less important than sourcing high-quality deals. ESOPs offer a unique way to create shared value between the fund and its team members.

Whether structured as phantom equity, carve-out carry pools, or direct equity, ESOPs must be tailored to the fund’s business model, jurisdictional rules, and tax considerations. When implemented correctly, ESOPs not only motivate operational teams but also build a culture of ownership and accountability—an intangible yet critical factor for any successful VC fund.

Contributed by – Jidesh Kumar