This article is written by Isha Sharma, a 5th-year student at Bharati Vidyapeeth, New Law College, Pune. This article will lay out what actually constitute in all the sections and provisions of the Companies Act, 2013 and all the rules of Companies(Share and Debenture)Rule which states about the issuing of Sweat Equity Shares.

Introduction

It’s been said by Nina Agdal  ‘What you sweat is what you get’. In a similar way, sweat equity shares are shares which are  provided only to those employees and directors of the company who are hardworking and immensely dedicated towards their organisation or who have an idea of technical know-how of the business, or the employees who have an expertise or have contributed significantly to the intellectual property rights of the company. 

The top-grade employees or directors get the privilege of sharing a part of the profit in a way of ‘securities’ in return for the investment made by the investors. The shares are issued in the way of discount or consideration other than cash. 

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Meaning of Sweat Equity Share

In simple words, Sweat Equity Share is a reward given to employees by way of discount or consideration. Suppose an employee ‘A’ has contributed towards making a software for his/her company for the betterment and expansion of the company and as a result of it the company was rescued from paying the cost of the software, he ought to benefit. In this case, due to ‘A’ immense contribution towards the welfare of the company, the Sweat Equity Share is issued in lieu to ‘A’.

Sweat Equity Shares under the Companies Act, 2013

Section 2(88) of the Companies Act, 2013 states that Sweat Equity Share is a share which is issued by a company to its directors or employees at a discount or for consideration other than cash for providing them know-how or making available rights in the nature of intellectual property rights or value addition, by whatever name called.

Employees

Rule 8 of Companies (Share Capital and Debentures) Rules, 2017, defines ‘employee’ as an individual, who is a permanent employee of the company, working in India or outside India, for at least one year.

Value Addition

Rule 8 (1) of the Companies (Share Capital and Debentures) Rules, 2017 defines Value Addition as the benefit which is derived from an expert or professional for furnishing know-how or for Intellectual Property Rights that belong to them for which the consideration is not paid then the sweat equity share is issued to them. (1)

Importance of Sweat Equity Share

• The importance of sweat equity shares is majorly noticed by the start-up companies, as when a company is new or has freshly started up, it requires lots of funds to hire employees, or funds for promotion of the company, for marketing purposes and many more such services which are required for the expansion of the companies. The start-up companies usually lack funds to raise their capital due to which many times the startup company fails to survive in the long run. As the funds are low so it’s hard to provide any monetary rewards to the employees working in the start-up company which may sometimes be little demotivating for the employees who are putting their effort and toil. In such cases, sweat equity shares provide the shade to the start-up companies which help them grow through the market competition and survive in the long run. 
• The sweat equity shares also play an important role in large, well-settled companies as these companies have large funds to invest in the market and get securities in return, and these return can be shared with the hard-working employees of the company who are entitled to  such rewards exclusive of their remuneration. It also helps in boosting the morale of such employees for a better working environment in the company. Employees with special knowledge, having technical know-how deserve to be rewarded apart from their basic remuneration.

Conditions for issue of Sweat Equity Share

Section 54 of the Company Act, 2013 lays down conditions to be complied with while issuing sweat equity shares. When the shares are issued to the employees under Rule 8 (1) of the Companies (Share Capital and Debentures) Rule, 2014 whereby passing a special resolution  as mentioned under Section 54 of the Company law, then following details like  number of shares, the consideration price, the market price and the class of employees have to be specified.

In the case of listed companies, SEBI guidelines have to be followed and in the case of an unlisted company, Rule 8 will be complied with. Rule 8 states that the special resolution will be valid only for 12 months, and within that time span the sweat equity shares may be issued.

Sweat equity share can be issued only when the following terms are fulfilled:

1. A special resolution is needed to be passed with the permission of  3/4th members entitled to do so. The allotment is required to be made within the set period of 12 months from the date of passing the special resolution.
2. The company is not allowed to issue the share for more than fifteen percent of the existing paid-up equity share capital in a year.
3. The number of shares, current market price, consideration price, class of directors and employees is required to be specified in the resolution.
4. In the case of listed companies where the equity share of the company is listed then the Securities and Exchange Board of India’s Regulation,2002 will be followed and in case of non-listed companies, the securities are issued according to the rules prescribed. [Section 54(1)(d)]
5. The sweat equity share shall be locked in and non-transferable for a period of three years from the date of allotment when issued to employees or directors.
6. The company is required to be incorporated at least for a year.
7. Proper justification has to be given for the value of sweat equity share when determined by a registered valuer.
8. For the purpose of sections 197 and 198 of the Act, the amount of sweat equity share will be treated as part of managerial remuneration, if the following conditions are fulfilled:

1. When the sweat equity shares are issued to any director or manager.
2. When they are issued for consideration other than cash which will be carried to the balance sheet of the company. (2)

Quantum of Sweat Equity

The company is allowed to issue only 15% of the existing paid-up equity capital in a year or shares of the value of rupees 5 crore, whichever is higher and in case of any exceeding of the percentage or in the value of shares prior permission has to be obtained from the central government.(3)

Provided that in the case of issuance of the sweat equity share shall not exceed 25% of paid-up capital at any time in the company and also provided with an exception where sweat equity share can be exceeded up to 50% and not beyond that of its paid-up capital up to five years from the date of its incorporation in case of start-up companies recognized by the Government of India(4)

Valuation of Sweat Equity Shares

The procedure for valuation of sweat equity shares are as follows:

1. A registered valuer is required to determine the price limits of the sweat equity shares that are to be issued.
2. After determining, he is required to submit a proper valuation report justifying the reason for such valuation to the Board of Directors.
3. The valuer is required to take account of all the details of intellectual property rights and know-how of any value additions made by the employee for which the sweat equity shares are being issued.
4. After taking account of all the information mentioned under points (A), (B) and(C) a copy of gist has to be sent to the shareholders providing the notice of the general meeting.

Procedure for issuing

The first step to issue the sweat equity share is by passing a special resolution at a general meeting which is held by summoning the board meeting in order to consider the proposal on the issue of sweat equity shares and to fix up the date, time, place, and agenda for the same.

Second, the resolution is passed by the majority votes of the shareholders through postal ballot as specified under companies(Passing of the resolution by Postal Ballot) Rules,2001 which shall also be adopted and this Special Resolution will be filed with the Registrar of Companies (ROCs) in Form. No. 23.

Third, after the Special Resolution has been passed the Explanatory Statement is maintained consisting of the following details:

1.The time, date and venue of the meeting

2.Reasons or justification for the issues;

3.Numbers of shares, consideration and the class of persons to whom such equity shares to be issued

4.Value of the Sweat Equity shares along with the valuation report.

5.Name and details of the person to whom the equity share will be issued and his/her relation with the company.

6.The rate of sweat equity share

7.The issuance of such equity which may affect the ceiling of managerial remuneration. 

8.The accounting policies specified by the Central Government affecting the company’s statement.

9. Diluted earnings per share shall be calculated in accordance with the Accounting Standards specified by the Institute of Chartered Accountants of India.

Fourth, in the case of any shares to be issued on the day of a grant of sweat equity share is equal to or exceeds 1% of the issued capital (during any one year, to identify employees and promoters) then a separate resolution shall be passed.

Fifth, once the approval is made by the shareholders, sweat equity shares are issued and allotted by the Board of Directors to the respective directors or employees then the company is required to file e-form-2 and e-form 3 with the ROC in due course. 

Sixth, once the resolution is filed with the registrar in Form MGT-14, a board meeting is called up with the way of due notice to approve the allotment of sweat equity shares accordingly.

Seventh, once the resolution is passed for the allotment of the shares the company is required to file Form PAS-3  within 30 days of passing of the Board resolution for the allotment of sweat equity share.

Eighth, on allotment the company is required to maintain a register of Sweat Equity in Form SH-3 at the registered office of the company or any other place as the board may decide.

Ninth, the entries made in the register has to be authenticated by the Company Secretary appointed by the company or any such other person appointed by the Board of Directors of the Company. (5)

Issue by a listed company 

Sweat equity share is issued to employees and directors in the way of discount or consideration other than cash by the companies whose equity shares are listed on a recognized stock exchange in accordance with section 79A of the Companies Act, 1956. Nothing contained in these regulations can be applied to any unlisted company. 

General Meeting is held by calling Board of Directors with at least 7 days prior notice to propose the purpose of passing a special resolution for considering the issue of sweat equity shares clause (a) of subsection (1) of Section 79A of the Companies Act, 1956 in which explanatory statement to be annexed. The promoters will be subjected to the requirement according to the procedures specified in Regulation 6 of these Regulations; the promoters to whom such sweat equity shares are to be issued are not allowed to participate in such resolution.

Pricing of Sweat Equity Share by the listed company

The price set up for the sweat equity share shall not be less than the higher of the average of the weekly high and low of the closing prices of the related equity shares during the last six months preceding the relevant date or during the two weeks preceding the relevant date, whereas ‘Relevant Date’ here means the date which is thirty days prior to the general meeting held by the shareholders.

In case where the shares are listed in more than one stock exchange but shown by only one on the given date of the stock exchange then the price of that stock exchange will be considered; also when the shares are repeated(quoted) in more than one stock exchange then the stock exchange with the highest trade volume during that day will be considered.

If the shares are not shown on the given date then the next day of quoting that share will be considered.

Valuation of Intellectual Property by the listed company

The valuation of intellectual property rights of know-how of other value addition is done by the merchant banker.The duty of a merchant banker is to consult such experts and valuer as he deems fit in regard to the nature of the industry and property or other value addition.

The merchant banker is also required to get a certificate from an independent chartered accountant to make sure that the valuation of intellectual property or any other additional valuation is made in accordance with the relevant accounting standards.

Accounting Treatment

Sweat Equity shares are issued for non-cash consideration it is usually treated in the form of depreciable or amortizable assets (amortizable and depreciable is a method of spreading the cost of an asset over a specified period of time), which is to be carried by the balance sheet according to the relevant accounting standards.

When not treated as an amortizable asset it will be mentioned as expenses (as when it is issued for non cash then the capital side gets increases and asset side remains the same so just to maintain the balance of both the side, we nullify and give the reverse effect in the balance sheet), as provided by relevant accounting standards.

Placing of Auditors before Annual General Meeting:

The Board of Directors is required to place a certificate regarding the issue of sweat equity share before the shareholders to make sure that the sweat equity share has been issued in accordance with the Regulations and Resolution of the issue of sweat equity share by the company.

The Ceiling on Managerial Remuneration

For the purpose of section 198, 309, 310, 311 and 387 the amount of sweat equity share will be issued as a part of Managerial Remuneration only on the following grounds:

• The sweat equity share is issued to any director or manager; and
• They are issued as consideration other than cash.

Lock-in of sweat equity shares

The Securities and Exchange Board of India (Disclosure and Investor Protection) Guidelines, 2000 will make a contribution after the issuing of sweat equity shares only if a company makes a public issue; The Sweat Equity share shall be locked in for a period of three years from the date of allotment.

Listing

The sweat equity share will be listed by the company only if it has complied with all the Regulations and Resolutions.

Applicability of Takeover

It will be applicable only if it has acquired with all the provisions of the Securities and Exchange Board of India (Substantial Acquisition of Shares and Takeovers)Regulations 1997.(6)

Issue by an unlisted company

The sweat equity share of the unlisted company is issued by the way of writing 7 days prior notice to all the directors mentioning the agenda and venue to address a Board Meeting for the proposal of issue of sweat equity shares( 79A of the Companies Act, 1956).

The company is required to ensure that the share capital of the company is increased by the proposed issue of sweat equity shares and if not then necessary steps have to be taken to increase the authorized share capital of the company; The company can issue share capital only after the expiry of one year in which the company was entitled to commence.

Pricing of Sweat Equity Share by the Unlisted Company

The company is not allowed to issue sweat equity share more than 15% of the existing paid-up equity share capital in a year of shares issued in the value of Rupees 5 crores, whichever is higher.

In case of issuance of sweat equity shares in the company shall not exceed 25% of the paid-up equity capital of the company at any time.(Rule 8(4) of the Companies Share Capital and Debenture Rules,2014).

Valuation of Intellectual Property by the unlisted company

To determine the fair price for the issue of sweat equity share, valuation report is obtained by the registered valuer to keep a record of valuation of intellectual property rights or of know-how provided or other value additions for which sweat equity shares are to be issued and also a proper justification is required to be given for the same. [Rule 8(6) and 8(7) of the companies (Share Capital and Debentures) Rules, 2014] 

Accounting Treatment

When a sweat equity share is issued for non-cash consideration it takes the form of depreciable or amortized asset which is required to be carried to the balance sheet according to the accounting standards, or if it’s not issued for non-cash consideration then it will be expensed off  just to nullify the effect (as when it is issued for non cash then the capital side gets increases and asset side remains the same so just to maintain the balance of both the side, we nullify and give the reverse effect in the balance sheet) , as provided in the accounting standards.

When a sweat equity share is issued during an accounting period, the accounting value of it will be treated as a part of the compensation to the employee or the director in the financial statements of the company, if it’s not issued according to the acquisition of an asset. [Rule 8(11) of the Companies (Share Capital and Debentures) Rules, 2014]

The ceiling of Managerial  Remuneration in an unlisted company:

The amount of sweat equity share will be treated as a part of managerial remuneration in accordance with the purpose of section 197 and 198 of the Companies Act, 2013 if the following conditions are fulfilled:

1. The sweat equity share shall be issued to any director or manager; and
2. They are issued for consideration other than cash. [Rule 8(10) of the Companies (Share Capital and Debentures) Rules, 2014]

Lock-in of sweat equity shares

The sweat equity shares issued to employees and directors are required to be locked in/non-transferable for a period of 3 years from the date of allotment, and the share certificate of lock-in has to be stamped in bold or mentioned in a prominent manner the expiry of the lock-in period of the sweat equity shares.[Rule 8(5) of the Companies (Share Capital and Debentures) Rules, 2104].

Disclosures in the Director’s Report

For the fair valuation of the sweat equity share it is important to make a proper disclosure of the Director’s report. The director is required to disclose all the financial statement of the year and Report of Directors should be attached to the Balance Sheet laid before the AGM.

The intention of the Director’s report is to provide the shareholder with the overall financial statement, operation and business scope of the company in a detailed form. Many previous provisions of the Companies Act, 2013 makes it mandatory to disclose the Director’s Report which was later amended by the Central Government in the Companies Act, 2017.(7)

The following are the details of the Sweat Equity Share which is required to be disclosed in the Director’s report of the year:

1. Detailed information of the class of directors and employees to whom the sweat equity shares are to be issued.
2. Detailed note of the class of shares issued as Sweat Equity Shares ;
3. Numbers of shares issued to employees and directors and as well as key managerial personnel showing the number of such shares issued to them as consideration other than cash and names of the individuals holding one per cent or more of than one per cent of the issued share capital.
4. Proper justification of the issue of shares to be mentioned.
5. The terms and conditions for the issue of the shares to be mentioned along with the price formula.
6. A total number of shares arising as sweat equity shares and the percentage of the shares of the total post issued and paid-up share capital is to be mentioned.
7. Any sort of amount of benefit received to the company in accordance with the issue of sweat equity shares.
8. The diluted earnings per share (EPS) is calculated to gauge the quality of the Company’s earning per share for the issuance of sweat equity shares. (8)

Sweat Equity Shares Accounting Treatment

When the sweat equity share is issued for a non-cash consideration the following steps are required to be taken according to the valuation report thereof obtained from the registered valuer :

Firstly, when the sweat equity shares are issued for non-cash consideration it is treated as a  depreciable or amortizable asset and shall be carried to the balance sheet according to the accounting standards, whereas if not issued for non-cash consideration then it will be expensed off as per the accounting standards.

Secondly, as per the Sections 197 and 198 of the Act the amount of sweat equity share will be treated as a form of managerial remuneration if the following conditions are fulfilled:

1. If the sweat equity shares are issued to any director or manager; and
2. If they are issued by the way of consideration other than cash which does not take the form of an asset that can be carried to the balance sheet of the company as per the accounting statement.

Thirdly, when the sweat equity shares issued in an accounting period the amount of sweat equity share will be treated as a form of compensation to the employees or the directors in the financial statements when the shares are not issued pursuant to the acquisition of an asset.

Fourth, In case when shares are pursuant to the acquisition of an asset, whose value is determined by the valuation report will be carried in the balance sheet as per the Accounting Standards and such amount of the accounting value which exceeds the amount of assets acquired will be treated as a form of compensation to the employee or the director in the financial statement as per the valuation report of the company. (9)

Startups and sweat equity

Startup companies in India has been a platform for the many new digital businesses with the intention of the government to set up a new digital economy which has achieved great success like UPI,BHIM, e-KYC etc, but still there are many startup companies who have been struggling to make an impactful entry due to the high and increasing competition it is facing many obstacles as a founder.Starting out company can be the biggest challenge for that company to survive in the long run.

The Prime Minister Narendra Modi along with the Finance Minister Arun Jaitely announced their Budget of the year 2016 which intended to provide multiple benefits to startup companies and a  clean environment for them to set up and prosper in the compex Indian regulatory setup. The relaxation was provided to the two provisions of the Companies Act, 2013 regarding inability to accept Employee Stock Options (ESOPs) and the limited leeway to startups for issuing sweat equity.

ESOPS and sweat equity shares play an important role as startup company were dependent to seek equity funds from investors (seed funder, angel investors, venture capitalists, and private equity funds, in that order) where there was a chance of natural consequences for the founders to dilute in their own equity holding, which could lead to losing the principal control over their startup and also cut the benefits of the startup’s success.

The position after the Amendment made under the Companies (Share and Debentures) Third Amendment Rules 2016 for the norms of ESOPs and sweat equity for startups have been very helpful as:

1.  ESOPs now allowed companies that qualify as ‘startups’ to issue ESOPs to founders or even to those directors that hold more than 10 percent of the share capital which was previously not permitted. 
2. Whereas the Amendment liberalised the issuance of sweat equity shares by increasing the limit up to 25 percent of the paid-up equity share capital to 50 percent to the companies qualifying as ’startups’.

After 16 January 2016 when the Government intended to make a digital economy by helping out with tremendous benefits to promote the startup companies, new Amendments were added in the Companies (Share and Debentures) Rules,2014 which lead to the benefits like where any employee joining the company was able to issue a sweat equity shares, which was an advantage to the employees as they were duly awarded for any  ‘value addition’ from the time of joining the company.

The startup companies can issue sweat equity shares within one year of commencement of business which was not the case earlier as many restrictions prevailed with the issue of sweat equity share.

The impact of this Amendment has been very powerful to many Indian startups as they are externally funded which helped them to figure out legitimate means of maintaining their shareholdings at meaningful percentages of the fully diluted share capital, which advantaged them in seeking better growth for their company and faster exit. Both the changes helped in providing a leeway to founders for the better structuring their cap tables. (10)

Taxability of sweat equity shares 

To make the sweat equity shares taxable in the hands of employees at the time when the shares are transferred or allotted the following conditions are required to be satisfied:

1. The security is required to be either a specified security or sweat equity shares as defined in Section 2(h) of the Securities Contract (Regulation) Act, 1956.
2. Such security are required to be allotted or transferred on 1st April 2009 or after and any security allotted or transferred before April 1, 2009 will lie under Fringe Benefit Tax.
3. Such security are allotted either directly or indirectly to the employee or former employee.
4. Such security or sweat equity shares are allotted by the employer or former employer to the employee.
5. The security allotted may be either free of cost or at a concessional rate.

Calculation of Fair market value

After the above conditions are satisfied the taxable amount is calculated by the valuation of fair market value of securities at the date of exercise of an option by the employee.

Whereas, fair market value will be calculated as:

 Quoted Shares

1. If the share of the company are listed on any stock exchange then  –  average of opening price and closing price
2. If the share of the company are listed on more than one stock exchange then  – average of opening price and closing price in the stock exchange in which highest volume is traded.
3. If the share is not traded on the date of exercise of option then the fair market value be the closing price of the shares on any stock exchange on a date closest to the date of exercise of option will be taken as fair market value. 

Unquoted Shares:

In case where the shares are not listed on any stock exchange then the Merchant Bankers are required to determine the fair value of shares on the specified date; Specified date is a date where the option is exercised or any date earlier to it and not being a date which is 180 days earlier than the date of exercise of that option.

Conclusion

Sweat equity share has been a great help to all those employees who have contributed immensely towards their services and provided some sort of benefits to the company in a way of intellectual property rights or any other value addition. Sweat equity share is provided to such employees apart from their remuneration, where they’re able to hold a part of share in the investment made by the companies. 

The post scenario of 2016 was very impactful as the Government of India also come up with some new amendments for the issue of sweat equity shares in the Companies (Share and Debentures) Third Amendment Rules, to include some special provisions for startup companies in India. Overall an effective step has been provided till now for the welfare of the employees who has just joined the company.