Founder Vesting Clauses in Indian Startup Shareholders’ Agreements
Introduction : When co-founders of a startup set up a company, they normally get ordinary paid-up equity as shares. When one of them leaves the company too soon but has a big stake in it, it may cause an inconsistency between his contribution and ownership, disadvantageous to the remaining founders and making future fundraising difficult. In order to eliminate this problem, shareholder agreements usually provide for certain conditions of share vesting, also known as “reverse vesting”, as well as good- and bad-leavers buyback options.
Indian company legislation does not recognize shares that have not yet been vested as a separate category of capital. After being allotted to the owners, shares begin to have full rights in accordance with their class. This implies that vesting is a contract that together with a call option establishes a ban for the owners to sell their shares.
This blog explains the overlay which is a difference between a restriction binding on the company and a restriction binding only on the shareholders. The discussion involves the various cases starting from V.B. Rangaraj continuing with Vodafone, Messer Holdings, and World Phone India; the statutory restrictions regarding company buyback; the limits set by the restraint of trade doctrine established in Percept D'Mark on referring bad leaver clauses; the principle of liabilities stated in Section 74; and the tax treatment of below-market founder exit under the present direct tax laws taking the transferor and transferee into consideration.
Legal Provisions
According to the Companies Act of 2013, Section 2(68)(i) mandates that a private company must limit the right of share transfer as per its Articles of Association. Section 44 views shares as movable property that can be transferred in any way as prescribed in the Articles. Section 56(1) prohibits transfer registration without submission of the appropriate document that has been duly stamped and executed in the last sixty days. Section 58(1) provides that a private company may deny transfer registration based on existing rights within its Articles and will have to issue a notice within the next thirty days.
Sections 68 to 70 along with Rule 17 of the Companies (Share Capital and Debentures) Rules, 2014 govern company buyback. Section 68(2)(a) mandates the buyback must be authorised by the articles. The funding must be through free reserves, securities premium or proceeds from a fresh issue under Section 68(1). The ceiling on buyback is twenty-five per cent of paid-up capital and free reserves with a board resolution threshold of ten per cent in terms of Section 68(2)(b). Section 68(2)(d) mandates that the debt-equity ratio post-buyback should not be more than 2:1, and Section 68(2)(e) states that shares should be fully paid up. In the proviso Section 68(2), it is specified that no further buyback can be offered within a year.
The Indian Contract Act, 1872, in its Section 27, states agreements making it unlawful for people to carry on any legitimate profession, trade, or business, except for the provision about the seller of goodwill. Section 74 limits the damages for breach of contract to the amount of reasonable damages, which is not greater than the amount specified in the agreement.
Regarding taxation, two important provisions of Income-tax Act, 2025 are applicable in a situation of the below market exit of the founders. On the transferor side, the provisions of Section 79, say that if the amount received during the transfer of a family share is less than the fair market value of that family share computed in accordance with the rules prescribed, then that fair market value shall be treated as the full value of consideration under Section 72, the capital gains calculation provision. However, Section 79(2) excludes any transfer of the specified category of persons based on specified conditions. Moreover, Section 79(3) gives the definition of “quoted shares” as those shares that are quoted regularly on the recognized stock exchange based on actual transactions. Since startup shares are not listed, they fall under Section 79.
According to Section 92, income earned by the recipient must be classified as "Income from other sources," which refers to income not included in any other specified headings. Section 92(2)(m)(iii) states that in any tax year, if a person has received anything other than real estate property, without any payment, and the cumulative fair market value is more than ₹50,000, the entire fair market value will be taxed. However, if one has received property with a value lesser than ₹50,000, the amount liable to taxation will be the value which is in excess of the amount paid as consideration. In Section 92(5)(f)(ii), the term “property” means "shares and securities." And Section 92(3) states that amounts received in the form of gifts from a relative, which include marriage gifts, inherited money, gifts from local authorities, and non-profit organizations (unless otherwise provided), amount to receipts from a trust related to a relative in the lookout— none of these is likely to apply and therefore transfer of unvested shares between unrelated co-founders or to an unrelated employee trust would not be profitable. Section 93, which addresses deduction from income from all other sources, does not have an applicable deduction for shortfall as per Section 92(2)(m)(iii).
According to the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019, Rule 21 mandates that any transfer between resident and non-resident should not be underpriced, and transfer from non-resident to resident should not be overpriced.
Legal Analysis
Reverse vesting is a contract, not a class of capital
Reverse vesting does not form a separate legal category of conditional equity. The shares given to the founder remain subject to the rights connected to their class, the articles, and the governing agreements. The reverse vesting agreement forms a contractual means of transferring or acquiring shares under specific terms; it does not, in itself, stop the rights connected to the shares from existing. As for its contractual side, it is a form of a call option: the founder agrees that if his direct relationship with the company finishes before a definite event takes place, the other founders or their representative can buy back the unvested shares for a predetermined price.
Two layers of enforceability: the company and the signatories
The primary legal question at issue is whether a vesting limitation or any call option in an SHA binds the company and not only the signatories to each other. There are two layers of answers to this question provided by the case law.
Company-level enforcement requires incorporation in the articles
The Supreme Court in the case of V.B. Rangaraj v. V.B. Gopalakrishnan determined that the restriction on the transfer of shares in a private firm is not applicable to the company and its shareholders without its presence in the Articles of Association. Two decades later, in the case of World Phone India (P) Ltd. v. WPI Group Inc., USA, the Delhi High Court stated the same principle in relation to the shareholders' agreement of a private company. The implementation of a provision from an SHA that is not included in the articles is not possible for the company, notwithstanding the fact that there is nothing in the Act preventing this provision. The importance of the case of World Phone is that it was decided after Vodafone and took into consideration the comments made by the Supreme Court in terms of SHAs in that case, stating that it does not disturb Rangaraj with regard to what is binding on the company. This creates a significant practical implication for founder vesting: a board cannot use an unincorporated SHA to deny to register the transfer under the provisions of Section 58(1) and treat unvested shares as being subject to a call option the articles do not recognise.
Inter se enforcement does not require incorporation
The significance of Vodafone and Messer Holdings can be explained here. In the case of Vodafone International Holdings BV v. Union of India, the Supreme Court defined a shareholders' agreement as a private contract amongst shareholders and binding only among themselves provided that its terms are not inconsistent with the articles of association and if there is an inconsistency, the articles would take precedence. In Messer Holdings Ltd. v. Shyam Madanmohan Ruia, the Bombay High Court Division Bench took the inter se principle further by ruling that consensual arrangements made by a few shareholders to restrict the transfer of their shares are indeed private arrangements that do not infringe upon the principle of free transferability of shares and such arrangements could be enforced amongst the parties. The ruling in Messer Holdings arose in the context of a public limited company under the provisions of Section 111A of the Companies Act, 1956, and the Supreme Court in that case understood Rangaraj as a ruling on the Company’s compliance as opposed to the validity of the agreement between the parties.
When read together, these four decisions create an actionable rule of thumb for how to treat founder vesting. A vesting clause existing solely in the SHA remains an enforceable obligation by the co-founders that would provide the breaching party with a cause of action for damages and, depending on the applicable limits on obtaining specific performance, a right to obtain equitable or injunctive relief against the breaching co-founder. But it does not provide the company with any rights of its own. The board would not be able to deny the registration of the transfer of unvested shares, treat the call option as self-effectuating, or deprive the parties of their membership rights. For the purpose of accomplishing that, the vesting schedule, call option, and leaver pricing need to be part of articles. That requirement is not just a matter of formality for startups that want to raise institutional investments — investors will inspect working of the articles, not SHA.
Buyback is not a substitute for a transfer mechanism
In an instance where a leaving event causes a repurchase, a corporate buyback process according to sections 68 to 70 of the Companies Act will still require the authorization of the articles of association and the use of allocated reserves along with relevant limits and solvency as well as the one-year gap after the previous buyback, which cannot be replaced by provisions of a shareholders agreement. The feasibility of this whole process depends on the level of reserves and the solvency of the company and not simply on the fact that it operates at a loss now. If these conditions cannot be satisfied, then the alternative would be making a second transfer to the remaining founders or an employee trust according to section 56; yet, the transfer procedure has to comply with the standard rules and tax implications.
Bad-leaver clauses: the restraint-of-trade limit in Percept D'Mark
Generally speaking, bad-leaver clauses classify any departing founder as a “bad leaver” when that individual goes on to participate in competing business activities. The significance of Section 27 comes into play in this instance. The Supreme Court has interpreted the provision in Percept D'Mark (India) (P) Ltd. v. Zaheer Khan to mean that any restraint of a person’s right to professionally pursue an occupation after termination of a contract is void under Section 27; in contrast to the position in England, Indian law does not allow for a reasonableness assessment in case of a post-term constraint. The Court attempted to differentiate between two forms of constraints: those imposed during the contract, which, in effect, serve as part of the deal, and those imposed after the contract, which fall within the scope of Section 27.
Referring to founder vesting, Percept D'Mark is unequivocal. A provision that makes vesting of shares contingent upon continued services such that a founder who departs before goals are attained does not receive shares that would otherwise remain unvested is valid during the time of engagement of the founder’s services and is a price adjustment instead of a restriction. On the contrary, a provision that has the effect of losing or retracting shares owned by an exiting founder only because they seek a competing position is intended to punish the founder for the practice of earning an honest living post-termination. The fact that the punitive action entails forfeiting shares instead of imposing an injunctive remedy does not change the position in law as to the validity of the provision: enforcement of a provision that is in fact a non-compete is not possible according to law indirectly through invalidation of shares. Consequently, the drafting of agreements should consider events leading to termination based on the conduct of parties during the engagement period rather than competition after the exit.
The penalty limit in Section 74
With accordance to Section 27, bad-leaver clauses forfeiting vested shares valuation in breach may still also be treated as penalties pursuant to Section 74, limiting all existing founders with respect to their remuneration to only reasonable compensation, as opposed to total forfeiture. Considerably lower valuation for unvested shares only and those shares which were not yet earned by the founder is also much more convincing, as in this case we rather talk about a situation where the founder relinquishes unearned benefits rather than paying for a breach. The difference between reducing the earned value and imposing a penalty for leaving the company is present in both Sections 27 and 74.
Tax: both sides of a nominal-price transfer
There is tax implications for both sides in a nominal-price leaver transfer. According to Section 79 in the case of the founder who is leaving, the law replaces the fair market value with the contractual price for calculating capital gains whenever the price is lesser. As for the founder who is acquiring the shares or a trust, Section 92(2)(m)(iii) inserts a tax on capital gains for the difference between the fair market value of the shares and the price that was actually paid, provided that this difference exceeds ₹50,000, since the term "property" in Section 92(5)(f)(ii) includes shares and transfers between co-founders typically will not fall under any exemptions in Section 92(3). As far as Section 93 is concerned, no deduction is given from this tax. Thus, introducing a nominal price in a leaver clause does not eliminate tax liability from either parties involved.
Oppression
In a situation where a leaver mechanism is not used as a pre-defined and time-based call, but instead serves to deprive the founder of power, the actions can be reviewed under Sections 241 and 242 of the Companies Act, 2013 on matters of oppression and mismanagement. A vesting provision agreed at incorporation, as long it works according to its terms, cannot claim this status.
Case Laws
V.B. Rangaraj v. V.B. Gopalakrishnan, (1992) 1 SCC 160 : AIR 1992 SC 453. A private family agreement restricted the transfer of shares in a private corporation even if it was not recorded in the Articles of Association. The Supreme Court ruled that restrictions which were not mentioned in the Articles would not bind the company or its shareholders, and thus if a transfer was made in violation of such agreement, it could not be refused registration on this basis. While the ruling deals with the company's liability, it does not mean that the relevant agreement is invalid with respect to its parties.
Vodafone International Holdings BV v. Union of India, (2012) 6 SCC 613. The Supreme Court also considered the subject matter of the shareholder agreement within the context of the Hutchison-Essar joint venture in a case dealing with tax aspects of indirect transfer. The court gave a characterization of the Shareholders Agreement as the private agreement existing between the shareholders themselves and being binding on them among themselves stating that the contents of the agreement cannot contradict the Articles of Association.
Messer Holdings Ltd. v. Shyam Madanmohan Ruia, 2010 SCC OnLine Bom 1284 : (2010) 159 Comp Cas 29 (Bom). A Division Bench of the Bombay High Court ruled that Section 111A of the Companies Act, 1956 (allowing shares in public companies to be freely transferred) does not preclude shareholders from agreeing to limit the transfer of their own shares, and that such agreements are valid among the shareholders without any necessity of incorporation into the articles of the company. The Bench understood Rangaraj to be dealing with the question of what binds the company and not with the validity of agreements among the shareholders.
World Phone India (P) Ltd. v. WPI Group Inc., USA, 2013 SCC OnLine Del 429 : (2013) 178 Comp Cas 173 (Del). In a case where the Company Law Board's decision was challenged, the Delhi High Court determined that an affirmative vote clause in the shareholders’ agreement that was not included in the articles of the private corporation did not entail enforcement against the corporation. The court found that Vodafone's view on SHAs did not lessen the significance of Rangaraj: the provisions under the Act foreseen as void cannot be enforced against the company unless provided for in the articles of incorporation.
Percept D'Mark (India) (P) Ltd. v. Zaheer Khan, (2006) 4 SCC 227 : AIR 2006 SC 3426. A contract relating to celebrity management claimed to impose a condition on the cricketer that, on the termination of the contract, he must provide the agent with a right of first refusal before hiring someone else as manager. The Supreme Court held that a restriction on the exercise of a legitimate profession following the end of a contract was void under Section 27, and that the concept of reasonableness concerning restrictions operating for the duration of the contract did not apply to restrictions that do not operate thereafter. The ruling is an unequivocal precedent against provisions about the cancellation of shares as a result of breaching the non-competition obligation after quitting.
Practical Implications
Put the vesting mechanism in the articles at incorporation
According to Rangaraj and World Phone India, a restriction that is limited to SHA cannot back a board's refusal to register transfers in relation to Section 58(1). Vodafone and Messer Holdings imply that SHA should oblige the co-founders in their personal capacity, though the personal claim against a co-founder who has left would not be ideal replacement of a mechanism at the company level in registration.
Do not assume a buyback is available
The boards are expected to check for the actual reserves and solvency to be able to utilize Section 68, and, in cases this is not possible, transfer either from founder to founder or to the employee trust needs to take place.
Define bad-leaver events by conduct during the engagement, not competition after it
Based on the insight from Percept D'Mark, the forfeiture that results when competing actions occur after the exit from the firm constitutes a post-term restraint that is unenforceable under Section 27. Therefore, bad-leaver status can be aligned with certain conditions such as violations of material obligations, fraudulent actions, termination for cause, or voluntary resignation occurring before a milestone, and that happen before the founder actually exits the business.
Apply reduced leaver pricing only to unvested shares
Nonetheless, forfeiting vested shares upon breach is likely to be challenged under Section 74, whereas forfeiting shares that have not yet been earned will not raise similar issues.
Obtain a contemporaneous valuation before fixing the leaver price
Even if someone pays only a nominal price for something, it does not mean a person could escape tax liability - the capital gain of the founder leaving the company will be calculated under Section 79 based on the market value; the founder taking over in accordance with the founding agreement might be subject to tax under Section 92(2)(m)(iii) for that same shortfall; there might be no deduction according to Section 93 either. The situation intensifies if there is a foreign investor or founder involved: Rule 21 of the NDI Rules establishes the lower and the upper prices for the leaving clause.
Conclusion
The legal approach towards founder vesting in India relies on an understanding of unvested shares as a mere contractual tool and not as a type of capital recognized by law. Legal precedents have shown that vesting restrictions may be seen as valid contracts between the founders as per the decisions of Vodafone and Messer Holdings, however, they are binding upon the company only when they are recorded in the articles of the company as declared in the cases of Rangaraj and World Phone India. A company buyback is subject to the rules set forth by Section 68-70, which cannot be replaced by contractual terms. The leaver clauses have the possibility to modify the remuneration of a founder for shares that have not yet been earned. However, according to Percept D’mark, use of such clauses for punishing a legitimate profession carried out after exit is not permissible and any seizure of the already earned shares must be in compliance with Section 74.
The mechanism cannot be used for oppression of the founder either. Pricing has to comply with both the provisions available in Sections 79 and 92 of the Income-tax Act, 2025 since both statutes independently take over the statutory fair market value instead of the contractual price on one side of the deal. Proper documentation at the moment of the first allocation of shares, guided by contemporaneous valuation as well as a perfect understanding of the requirements of the taxation statutes, is the only means of ensuring protection.
Author: Sainika Saren in case of any queries please contact/write back to us via email to content@khuranaandkhurana.com or at Khurana & Khurana, Advocates and IP Attorney
References
Companies Act, 2013, No. 18 of 2013, §§ 2(68), 44, 56, 58, 68–70, 241–242 (India).
Companies (Share Capital and Debentures) Rules, 2014, Rule 17, G.S.R. 286(E) (India).
Indian Contract Act, 1872, No. 9 of 1872, §§ 27, 74 (India).
Income-tax Act, 2025 (India), § 79 ("Special provision for full value of consideration for transfer of share other than quoted share"), §§ 79(2)–(3), read with § 72.
Income-tax Act, 2025 (India), § 92(1)–(2)(m)(iii), (3), (5)(f)(ii) ("Income from other sources"; inadequate consideration on receipt of property including shares).
Income-tax Act, 2025 (India), § 93(1) (deductions from income from other sources; no deduction available against a § 92(2)(m)(iii) charge).
Foreign Exchange Management (Non-Debt Instruments) Rules, 2019, Rule 21, G.S.R. 706(E) (India).
V.B. Rangaraj v. V.B. Gopalakrishnan, (1992) 1 SCC 160 : AIR 1992 SC 453.
Vodafone International Holdings BV v. Union of India, (2012) 6 SCC 613.
Messer Holdings Ltd. v. Shyam Madanmohan Ruia, 2010 SCC OnLine Bom 1284 : (2010) 159 Comp Cas 29 (Bom).
World Phone India (P) Ltd. v. WPI Group Inc., USA, 2013 SCC OnLine Del 429 : (2013) 178 Comp Cas 173 (Del).
Percept D'Mark (India) (P) Ltd. v. Zaheer Khan, (2006) 4 SCC 227 : AIR 2006 SC 3426.
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