ESOP reform, MSME capital, and the new architecture of startup value creation after Budget 2026

Over the past five years, India’s startup ecosystem has shifted from a phase of abundant capital and rapid scaling to one characterised by funding moderation and valuation resets, resulting in longer paths to liquidity.

Between 2020 and 2022, Indian startups raised over $120 billion in venture funding, driving aggressive hiring and expansion. From 2023 onwards, funding volumes declined sharply, and IPO timelines were pushed out. Profitability replaced growth at any cost as the primary operating focus.

It is within this changed environment that the Union Budget 2026 has assumed significance, not as a reset, but as a signal of how India intends to structurally support its startup and MSME ecosystem through the next phase of growth.

Budget 2026 laid out a strong support framework for MSMEs, including a Rs 10,000 crore SME Growth Fund, a Rs 2,000 crore top-up to the Self-Reliant India (SRI) Fund, and expanded TReDS-linked measures to improve credit access and liquidity for small businesses.

These interventions are particularly relevant for startups and deeptech ventures, many of which operate as MSMEs during their formative and scaling years. While access to capital and liquidity remains essential, the Budget also brings into sharper focus a structural friction that was previously masked by easy capital: the challenge of retaining skilled talent in long-gestation innovation businesses.

Talent retention, ESOP taxation, and portfolio risk

As funding tightened and cash compensation flexibility declined, ESOPs became essential for aligning employee incentives with long-term enterprise outcomes. This is particularly true for deeptech and AI startups, where product development cycles can extend seven to ten years and require sustained commitment from highly specialised engineers and researchers.

India today has over 3,500 deeptech startups, yet continues to face a shortage of experienced talent in areas such as chip design, advanced AI modelling, and applied research. These professionals are globally mobile and actively recruited by companies in the US, the UK, Singapore, and Israel markets, where equity incentives translate more predictably into long-term wealth creation.

From a venture capital perspective, talent attrition is not merely an operational concern. It is a portfolio-level risk that directly impacts execution timelines, institutional knowledge, and valuation outcomes.

India’s current tax framework compounds this challenge. ESOP taxation occurs in two stages. At exercise, the difference between the fair market value of the shares and the exercise price is treated as perquisite income and taxed as salary, even though no liquidity is realised. At sale, the difference between the sale price and the fair market value at exercise is taxed as capital gains, typically 10-15% for listed shares and 20% or higher for unlisted shares.

While a limited tax deferral exists for eligible startups, the underlying cash-flow mismatch remains unresolved. For long-gestation deeptech companies and MSME-led startups with delayed exits, this significantly weakens the effectiveness of ESOPs as a retention tool.

Budget 2026, MSMEs, and the limits of capital-only support

The emphasis on MSMEs in Budget 2026 through the SRI Fund, SME Growth Fund, TReDS expansion, and initiatives such as She-Marts for women entrepreneurs acknowledges that small businesses and startups are central to employment generation and innovation.

However, while these measures address capital availability and liquidity constraints, they do not fully resolve the incentive misalignment faced by employees who are expected to commit to long-term value creation without near-term liquidity.

As MSMEs scale into venture-backed enterprises and innovation-led startups, equity ownership becomes a critical mechanism for shared value creation. Without corresponding reform in how ESOPs are taxed and structured, the benefits of improved capital access risk are being diluted by ongoing talent attrition and execution fragility.

Global comparisons and the case for reform beyond budget 2026

A comparison with global startup ecosystems underscores why ESOP policy has become a strategic lever in the competition for advanced technology talent. In the US, employee stock options are generally taxed closer to the point of sale, aligning tax liability with actual wealth realisation.

The UK’s Enterprise Management Incentive scheme applies capital gains tax upon exit rather than at exercise. Singapore allows tax deferral on qualifying employee share plans, while Israel has built an equity framework designed to support long-horizon innovation.

While India ranks among the world’s largest startup ecosystems by volume, it continues to trail the US and China in deeptech capital intensity and advanced research output. This gap is magnified when compensation structures fail to convert long-term value creation into tangible employee outcomes. Against this backdrop, venture capital firms increasingly view ESOP reform not as a tax concession, but as a structural necessity.

The opportunity now lies beyond Budget 2026. Linking ESOP taxation more closely to actual liquidity events, expanding the scope of deferral provisions, and simplifying compliance requirements would help address execution risks faced by venture-backed startups and MSMEs alike. As India seeks leadership in artificial intelligence, climate technology, and advanced manufacturing, such reform is foundational to sustaining long-term innovation and value creation.

Ranjeet Shetye is a Deeptech Investor, Mentor at YourNest VC, COO, and CPTO at MapMyCrop