Do ESOP Shares Need to Be Dematerialised in India? The Complete Answer for Startups

This question comes up at the intersection of two compliance requirements that most founders manage separately: the ESOP scheme and the demat mandate. Founders who have set up an ESOP programme are familiar with grant letters, vesting schedules, and exercise windows. Founders who are working through the demat process are familiar with ISINs, DPs, and DRFs. What is less clear to most is exactly how these two systems interact specifically, what happens to shares at the point of ESOP exercise, and whether those shares must be dematerialised.

The short answer is yes in most cases, ESOP shares that are exercised into actual equity shares must be dematerialised for companies subject to the MCA mandate. But the detailed answer has several layers: options themselves do not need to be demat, the obligation applies at exercise not at grant, the demat infrastructure must be in place before exercise can be processed compliantly, and there are employee-facing implications that most ESOP communication plans do not cover. This guide covers all of them.

KEY TAKEAWAYS

• ESOP options themselves are not securities and do not require dematerialisation options are contractual rights, not shares.
• Shares allotted when an employee exercises their options ARE securities and must be issued in demat form for companies above Rs 4 crore in paid-up share capital.
• If the company has not completed demat before an employee attempts to exercise, the exercise cannot be processed compliantly causing employee trust problems.
• Each exercising employee needs their own personal demat account before exercise can be processed this must be communicated well in advance of any exercise window.
• Exercised ESOP shares appear in the company's fully diluted cap table and must be reconciled with the depository records a gap here is a due diligence finding.

What ESOP Dematerialisation Actually Means The Precise Distinction

The confusion around ESOP demat starts with imprecise language. People ask 'do ESOPs need to be dematerialised?' when they mean different things at different stages of the ESOP lifecycle. The answer depends entirely on which stage of the lifecycle is being discussed.

The critical moment is exercise. Before exercise, the employee holds an option a contractual right recorded in the ESOP register, the grant letter, and the vesting schedule tracker. This requires no demat. At exercise, shares are allotted. Those shares are securities. For companies subject to the MCA demat mandate, those shares must be allotted in demat form credited directly to the employee's demat account, not issued as a physical certificate.

The Regulatory Basis: Why Exercised ESOP Shares Must Be Demat

The MCA Notification September 2024

The Ministry of Corporate Affairs notification effective September 30, 2024 requires private companies with paid-up share capital above Rs 4 crore to issue all new shares in dematerialised form. This applies to all new allotments whether to investors in a funding round, to promoters as bonus shares, or to employees exercising ESOP options. There is no carve-out for ESOP exercise allotments. If your company is above the Rs 4 crore threshold, every share you allot from the date of the notification must go into a demat account.

Section 62(1)(b) of the Companies Act 2013

The specific provision that governs ESOP issuances Section 62(1)(b) of the Companies Act 2013 provides for the issue of shares under an employee stock option scheme. The section does not independently specify the form of issuance (physical vs demat). However, the MCA notification creates an overriding requirement for demat allotment that applies to all issuances under Section 62(1)(b) for companies above the threshold.

The PAS-3 Filing Requirement

Every allotment of shares including ESOP exercise allotments must be reported to the ROC through Form PAS-3 within 30 days of allotment. For demat allotments, the PAS-3 should reference the ISIN under which the shares were allotted. For companies that process ESOP exercises in physical form when they are subject to the demat mandate, the PAS-3 creates a documentary record of non-compliant allotment a paper trail that surfaces during due diligence and regulatory review.

Also Read: Dematerialisation of Shares for Indian Startups: What It Means and Why It Matters

What This Means Operationally: The ESOP Exercise Flow With Demat

For a company that has completed demat ISIN allotted, DP appointed, all existing shareholders' holdings in the depository the ESOP exercise process with demat is straightforward. Here is how it works end-to-end.

ESOP Exercise Process in a Demat-Ready Company

Step 1 Employee submits exercise notice: Employee submits a written exercise notice to the company (or through the ESOP management software) specifying the number of options they wish to exercise and the payment method for the exercise price.

Step 2 Company verifies eligibility: Company confirms the options are vested, the exercise window is open, and the employee is eligible to exercise (no bad leaver trigger, no holding period restriction).

Step 3 Employee pays exercise price: Employee transfers the total exercise cost to the company's designated account. Exercise price = number of options x exercise price per share.

Step 4 Board resolution: The board passes a resolution allotting the shares to the employee at the exercise price, noting the employee's demat account details (DP ID + client ID).

Step 5 Demat allotment: The company instructs the DP to credit the allotted shares to the employee's demat account under the company's equity ISIN. The DP processes the credit through the depository system.

Step 6 PAS-3 filing: Company files Form PAS-3 with the ROC within 30 days of allotment, noting the ISIN and the number of shares allotted.

Step 7 ESOP register update: Company updates the ESOP register to reflect the exercise noting the date, number of shares exercised, exercise price paid, and demat account credited.

Step 8 Employee confirmation: Employee verifies the shares appear in their demat account. Company secretary confirms and files.

Timeline: Steps 1–8 typically complete in 2–3 weeks for a single employee exercise.

The Employee-Facing Requirement: Every Exercising Employee Needs a Demat Account

This is the operational detail that most ESOP communication plans miss entirely. When an employee decides to exercise their options, they need a demat account into which the shares can be credited. Without a demat account, the allotment cannot be processed. The company cannot issue the shares.

Why This Matters for Founders

Most employees who joined a pre-Seed or Seed-stage startup do not have a demat account for unlisted private company shares. They may have a trading account with Zerodha, Groww, or another broker for buying listed shares but these accounts may not be configured to hold unlisted shares, or the employee may not know that unlisted shares can be held in the same account. The company needs to proactively educate employees on this requirement before exercise windows open, not on the day an employee submits their exercise notice.

The Standard Demat Account for Resident Indian Employees

For resident Indian employees, a standard demat account with any SEBI-registered DP can hold unlisted private company shares. The account can be opened with most major brokers in five to seven business days. The employee needs their PAN, Aadhaar, a bank account, and in-person or digital KYC. There is no additional requirement for holding unlisted shares the same account that holds listed shares can hold unlisted ones. The company should communicate this clearly and provide the employee with a list of recommended DPs if they do not already have an account.

NRI Employees

Employees who are Non-Resident Indians at the time of exercise face additional complexity. An NRI employee cannot hold unlisted Indian private company shares in a standard resident demat account. They need an NRO (Non-Resident Ordinary) demat account linked to their NRO bank account, or in some cases an NRE account. The account-opening process for an NRI takes three to five weeks and requires overseas address proof and FEMA-compliant documentation. If an NRI employee is approaching the end of their exercise window and does not have the right account type, the company needs to flag this well in advance waiting for the exercise notice to discover the problem adds weeks and may result in the window expiring.

What to Include in Employee ESOP Communication

Every ESOP grant communication should include a section on demat requirements at exercise. This does not need to be lengthy three to four sentences explaining that at the time of exercise, the employee will need a demat account, what type of account is needed for their situation (resident vs NRI), and who to contact if they have questions. Including this at grant time not at exercise time means employees have years to open the right account rather than days.

Existing ESOP Shares Issued in Physical Form What to Do

Companies that processed ESOP exercises before the demat mandate came into force or before they had completed their own demat infrastructure may have employees holding physical share certificates from earlier exercises. These physical share holdings create specific problems.

Problem 1: They Are Invisible to the Depository

A share that exists only as a physical certificate is not reflected in the company's depository records. From the investor's due diligence perspective, the company's fully diluted cap table as shown in the depository system does not match its register of members because the exercised ESOP shares held physically are not in the depository. This is a due diligence finding that must be resolved before the cap table workstream can close.

Problem 2: They Cannot Be Transferred Through the Depository

An employee who holds exercised ESOP shares as a physical certificate cannot participate in a demat-processed secondary sale or ESOP buyback. The transfer must go through the depository system for demat-compliant companies, and a physical certificate cannot be transferred that way. If the company runs a buyback where all transactions are processed through the depository, employees with physical shares are effectively excluded which creates exactly the kind of inequity that destroys ESOP programme credibility.

The Resolution: Convert Existing Physical ESOP Shares to Demat

The fix is the same as for any other physical shareholder: the employee submits a Dematerialisation Request Form (DRF) along with their physical share certificate to their DP, the DP coordinates with the company's RTA for verification, and the depository credits the shares to the employee's demat account. For companies doing a portfolio-wide demat conversion, ESOP holders who have previously exercised should be included in the same shareholder outreach as all other physical certificate holders.

WARNING: Do Not Process New ESOP Exercises in Physical Form If Your Company Is Above the Rs 4 Crore Threshold

Any ESOP exercise processed after September 30, 2024 for a company above Rs 4 crore in paid-up share capital must result in a demat allotment, not a physical certificate. Issuing a physical certificate to an exercising employee after this date is non-compliant with the MCA mandate, creates a PAS-3 record of a non-demat allotment, and produces a shareholder whose holding does not appear in the depository system creating a reconciliation failure that will surface at the next due diligence.

If your demat infrastructure is not yet complete when an employee submits an exercise notice, do not issue physical shares as a workaround. Process the exercise notice, collect the exercise price, and hold the allotment until the ISIN is allotted and the employee's demat account is confirmed. Communicate the delay to the employee with a specific expected allotment date.

The Due Diligence View: How Investors Check ESOP Demat Compliance

Investors reviewing a company's cap table during Series A due diligence look specifically at the ESOP position not just the pool size and the grant register, but the exercised shares and how they appear in the depository system. Here is what the review typically covers.

• ESOP pool documentation: Scheme document, board resolution, shareholder resolution, ROC filings confirming the pool is legally established
• Grant register: Every grant listed with date, grantee, number of options, exercise price, vesting schedule, and current vesting status
• Exercised shares in depository: Every exercised option should appear as a credited share in the employee's demat account under the company's ISIN the investor will request depository statements from ESOP holders who have exercised
• PAS-3 filings for ESOP allotments: Every batch of ESOP exercise allotments should have a corresponding PAS-3 filed within 30 days and the PAS-3 should reference the demat allotment
• Leavers log: Employees who have left and had unvested options cancelled, with documentation confirming the cancellation and return of options to the pool
• Exercise price basis: The valuation report used to set the exercise price at each grant date must be Rule 11UA compliant

A gap in any of these items is a due diligence finding. The most common ESOP-related demat findings are: exercised shares not appearing in the depository (physical certificate holders), PAS-3 filings missing for historical ESOP allotments, and NRI employee holdings in incorrect account types.

How ESOP Management Software Simplifies the Demat Exercise Process

Managing ESOP exercises manually tracking exercise notices, coordinating demat allotments, updating the grant register, filing PAS-3s, and producing depository-reconciled cap table reports is operationally intensive once you have more than ten option holders. Every exercise event involves multiple steps across multiple systems. Errors in any step create discrepancies that require investigation.

ESOP management software like Tabulate Incentiv's cap table and ESOP management platform built specifically for Indian startups automates the tracking and documentation side of the exercise process. Grant records, vesting schedules, exercise notices, demat allotment records, and PAS-3 filing reminders are managed in one place with a complete audit trail. The software produces investor-ready cap table reports that reconcile the ESOP position including all exercised shares against the depository records, eliminating the manual reconciliation that creates errors.

For companies approaching their first exercise window particularly those with fifteen or more option holders implementing ESOP management software before the first exercise is significantly more efficient than trying to retrofit it after manual processes have already created a tracking backlog.

The Bottom Line

ESOP options do not need to be dematerialised they are contracts, not securities. But exercised ESOP shares are securities, and for companies above the Rs 4 crore paid-up capital threshold, every ESOP exercise allotment must be processed in demat form. This means the company must have its ISIN and DP arrangement in place before any exercise window opens, every exercising employee must have a demat account, and all previous exercise allotments in physical form must be converted before the cap table is presented to investors.

The operational implication is that demat completion and ESOP exercise windows must be sequenced carefully. If your company is planning its first exercise window perhaps timed to coincide with a funding round or an ESOP buyback complete demat first, communicate the demat account requirement to all potential exercising employees at least 60 days in advance, and do not open the exercise window until the infrastructure is in place. The exercise process is clean and fast when the infrastructure is ready. It becomes a compliance and relationship problem when it is not.

Also Read: The Hidden Cost of Delaying Demat

Also Read: Share Dematerialisation for Indian Startups: The Complete Guide

Frequently Asked Questions

Can an employee exercise their options and request a physical share certificate if they do not have a demat account?

For companies above Rs 4 crore in paid-up share capital and subject to the MCA demat mandate, no a physical certificate cannot be issued for a new allotment after September 30, 2024. The employee must open a demat account before the exercise can be processed. If the employee submits an exercise notice before having a demat account, the company should acknowledge the notice, collect the exercise price, and hold the allotment until the demat account is confirmed then process the demat allotment. Do not issue a physical certificate as a workaround.

Do unvested ESOP options appear in the company's depository records?

No. Options that have been granted but not yet vested, and options that have vested but not yet been exercised, do not appear in the depository system at all. Only shares which are allotted at the point of exercise appear in the depository. The ESOP pool (unissued reserved shares) and unvested/unexercised options are tracked in the company's ESOP register and cap table management system, not in the depository. The depository only records issued and outstanding shares.

What happens to an employee's demat account if they leave the company without exercising their vested options?

If the employee had exercised any options before leaving, those exercised shares remain in their demat account the employee owns them and the demat account is theirs to maintain. For unexercised vested options, the employee has their post-departure exercise window (typically 30–90 days) to exercise. If they exercise within the window, the shares are allotted to their demat account. If they do not exercise within the window, the options lapse and return to the pool and the employee's demat account, if it holds no company shares, simply sits empty with respect to this company's securities.

If a company has not yet completed demat, should it delay its ESOP exercise window?

Yes explicitly. Do not open an exercise window until demat is complete and every potential exercising employee has a demat account. Opening an exercise window before demat is complete forces you to either: (a) issue non-compliant physical certificates, creating a compliance problem and a depository reconciliation gap, or (b) collect exercise prices from employees and hold the allotment, which creates a trust problem when employees have paid money and cannot see their shares. Neither outcome is acceptable. Delay the exercise window, complete demat, communicate the delay to employees with a specific new date.

Does the demat requirement apply to ESOP shares in DPIIT-recognised startups?

Yes. The DPIIT recognition provides tax benefits for eligible employees specifically, the deferral of perquisite tax at exercise for up to five years, departure, or sale. This tax benefit is available regardless of whether the shares are held in demat or physical form. However, the MCA demat mandate applies to DPIIT-recognised startups above the Rs 4 crore threshold in the same way it applies to all other private companies. DPIIT recognition does not create any exemption from the demat requirement.