This article is written by Ayushi Sinha who is pursuing a Diploma in Companies Act, Corporate Governance & SEBI Regulations from Lawsikho.

Introduction

In an organisation, quite a few employees starting from the Directors to the unskilled employees put in work beyond their routine assignments by way of real hard work and help the company to surpass targeted goals and achieve even higher profits. To recognise, appreciate and reward their exceptional contribution these employees of the company are appreciated not just by way of salary or compensation hike, which are actually payments to perform a task well as per job profile but also awarded extra for their sweat invested by walking that extra mile to bring laurels to the company. It is a consideration other than in mere monetary form. It is a reward for the labours and hard work in providing intangibles, like adding to company’s goodwill or niche branding etc. This forms the basis ‘Sweat equity shares. Only it needs to be ensured that the employee eligible for sweat equity should not have been compensated by way of routine remuneration under the engagement contract for the value addition or contribution made by the employee.

Law underlying the concept of sweat equity shares

This concept was first employed in the United States in a self-help housing project way back in 1937. In India, this got specially enacted in 2013 and is read (a) for listed public companies in conjunction with provisions of the SEBI (SBEB) Regulations and (b) for unlisted companies is read with Share Capital and Debenture Rules, 2014 apropos Rule 8. The reference to sweat equity shares was there under the Companies Act, 1956 as well. It has been fortified by Section 2(88) of the Companies Act, 2013 which defines the “Sweat equity shares” as equity shares that are issued by a company to its directors or employees at a markdown or for non-cash consideration, for sharing their know-how or making available rights in the nature of intellectual property rights or value additions, by whatever nomenclature the same may be called. The Know how could be by way of creation of intellectual property rights like patent, trademark, copyright or value additions key to the company.

Sweat equity shares can be issued under the Section 2(88) of the Companies Act, 2013, by a company that qualifies as beneath:

• permanent personnel of the business house who are working in India or abroad from last one year 
• permanent workforces of the company’s subsidiary or of a holding company of the same 
• Full time Director of the Company

The scope of ‘employees’ and ‘value addition’ have also been defined and not left to interpretation on discretionary basis.

• Rule 8(1) of the Companies (Share Capital and Debentures) Rules, 2014 under the ‘Explanation (i)’ & (ii) paras defines ‘Employee’ and ‘Value Addition‘-
• Para (i) has been already defined in the preceding para as regards the definition of the term ‘employee’. The term ‘value addition’ under Explanation (ii) to Rule 8(1) of the Companies (Share Capital and Debentures) Rules, 2014, is explained as  expected economic profits derived by the company from a professional or a specialized domain expert for providing know-how or facilitating rights in the nature of intellectual property rights, by concerned person who is recipient of the sweat equity. Supposedly, it should not be for something against which the recipient has been compensated under contractual obligation by virtue of being on the rolls of the company. 

Reasons behind issuing sweat equity shares

Having dealt with the concept of sweat equity shares in the aforesaid paras, let us look in further details at the various reasons why companies resort to issuing of sweat equity shares.

1. The first, foremost and widely held reason is that it is an opportunity or a medium for the company to attract and retain its employees by acknowledging and rewarding their contribution beyond pay package. This helps in retention strategy as with the incentive and also the compulsory lock-in period of three years, i.e., non-transferable. It is a win-win situation for retention for the mentioned period to start with. Companies to retain employees and keep them motivated, often prefer employee stock options and sweat equity specially in their preliminary phases due to ambiguity, inability to pay industry prevailing salaries and unknown future growth path of the company. Moreover, the employees get the right to vote and receive dividends from the company as good financial/ business sense for owning this type of share.
2. Sweat equity is direct allotment of shares at a discount, i.e., the shares are immediately allotted to the employee and this feature holding of shares is often preferred over ESOPs (Employee Stock Option Plan) which is a right of the employee and not a obligation to him to buy some shares of the company at a pre-decided price to be allotted in the future thereby being dependent on price volatility of the shares.  
3. A registered valuer assesses the value at a fair price for the sweat equity shares. He evaluates and determines the value of know-how, of value additions, of intellectual property rights or any consideration. As against know-how, the shares may be issued at a discounted price or even free. In other words, this can be issued even below face value. Sweat equity only enjoys this exception in the Act and thus meets the dual objective of employer in rewarding without significant financial outgo. 
4. It is a way to reward beyond sitting fees for some independent directors who bring in out of box interventions which makes the company jump an orbit and assume a growth trajectory not achievable by organic growth pathway. Sweat equity can be issued to an independent director to acknowledge their contribution and keep them interested and continuing in the engagement for repeat tenures.
5. Company can issue Sweat Equity shares after remaining in business for one year only and the reward mode can be part cash, part IPRs/value addition and/or entirely non-cash consideration. So it is very effective during the initial years of stabilisation of the company floated as it gives flexibility and is less demanding on liquidity requirements and thus can be undertaken without rocking the boat.
6. No more than 15% of the existing paid-up equity share capital or INR 5 crore worth of share value, whichever is higher, is the ceiling beyond which sweat equity is not permitted to be issued. Moreover, 25% of the paid-up equity capital cannot be exceeded at any time at the time of issue of sweat equity. This ceiling helps to limit the risk exposure of the company. Further, pricing guidelines are well defined for Sweat Equity Shares and thus are again insulated from market driven price vagaries.

Also it will be in place to mention that a start-up company may issue sweat equity shares not beyond fifty percent of its paid up capital up to five years, from the date of its incorporation or registration as laid down in notification number GSR 180(E) dated 17th February, 2016 from DIPP (Department of Industrial Policy and Promotion) , Ministry of Commerce and Industry, GOI.

Procedure to be followed 

The procedure to be followed for these shares to be issued are broadly as under:

1. the date of the proposal for issue of sweat equity shares has to be approved by the Board 
2. the explanations or validation for the issue needs to be established
3. Under which category of shares are the sweat equity shares envisioned to be issued 
4. the total number of sweat equity shares to be allotted  
5. to whom such equity shares are being issued giving details of the class or classes of directors and/or employees 
6. the basis of valuation and the main terms and conditions under which sweat equity shares are to be issued
7. the association of such person with the company mentioning the time period 
8. the details of the directors or employees with names, relationship with the promoter are required before issue of the sweat equity shares to their crucial managerial employees
9. the price of sweat equity shares at which it proposed for issue
10. any consideration to be received for the sweat equity including consideration other than cash, if any 
11. in the event of the cap on managerial remuneration being breached by issuance of such sweat equity, the plans to deal with the same should be documented. 
12. a confirmation that company shall follow all the pertinent accounting standards
13. Consequent to the issue of sweat equity shares, the dilution in Earning Per Share and validation that applicable accounting standards have been followed for calculating the EPS
14.  Pass a special resolution after convening an Extra-General Meeting  
15. Within 30 days of passing the special resolution, the resolution is to be filed in Form No. MGT-14 with MCA 
16. Allot sweat equity shares to the employees in the meeting after calling the Board Meeting 
17. For allotting sweat equity shares within 30 days of the Board passing the resolution and filing the same in Form No. PAS-3
18. The Company must pay the stamp duty on issuance of share certificate as per the prevailing relevant state law
19. The Company must issue Share Certificates to the allottees within 2 months of allotment.
20. The particulars of Sweat Equity Shares issued need to be maintained in a Register by the company in Form No. SH-3.
21. The Company Secretary or an authorised person by the board shall validate the entries in the register 

The Board of Directors shall, inter alia, disclose the above details from (a) to (u), i.e., complete details of issue of sweat equity shares in the Directors’ Report for the year in which such shares are issued.

Conclusion

To briefly state about the accounting treatment of sweat equity shares, there are laid down guidelines for sweat equity shares issued for non-cash consideration and treatment of the same in the books of accounts of the company. If a depreciable or amortizable asset is the non-cash consideration then it needs to be carried to the balance sheet of the company in accordance with the accounting standards; or if it is not applicable, it shall be expensed as provided in the accounting standards. The amount against issue of sweat equity shares is considered as managerial remuneration as per sections 197 and 198 of the Act.

As regards the impending penalty for defaults, if any company and the directors fail to adhere with provision of sweat equity shares, there is no direct penal provision provided under the Companies Act, 2013. However, it provides that acts of omission or commission, default, malpractice etc for which no penalty or reprimand is provided in another place in this Act, the company and/or  concerned employee of the company shall be punishable with fine which may extend to Rs 10,000/- and where there are cases of  the perpetual contravention, the fine may extend to Rs 1000/-  for every day from the date of contravention.

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