In this article, Anith Johnson, pursuing a Diploma in Companies Act, Corporate Governance and SEBI Regulations from LawSikho.com and Shreya Mazumdar pursuing Diploma in Entrepreneurship Administration and Business Laws from NUJS, Kolkata discusses sweat equity shares.

Introduction

When an investor invests in the market, he tends to get certain ‘securities’ of the company in return for his investment. The investors can subscribe to equity shares, preferential shares or debentures that is issued by the company. Equity is like an ownership in a business. For instance, if A holds 90 shares of Mango Co. out of 9000 shares floated by the company then A is 1% owner of Mango Company. Hence if Mango makes a profit then A will get shares from the dividends and price appreciation but if Mango makes losses then A’s capital will go down which will reflect in the stock price.  

In its very general term ‘Sweat Equity’ is an input to a project or enterprise in the form of effort and labour.  Sweat Equity is as valuable as a cash equity. In case of a start-up of a company, sweat equity is typically rewarded through distributing stock or other types of equity in a new business. Sweat equity can be given to the employees as rewards as well as in the context of sweat equity in real estate which refers to a value-enhancing improvement made by homeowners to their properties.

The new era is keen to keep their best employees who bring in their expert knowledge, know-how as well as technical expertise that adds to the business value of the company. Therefore, in order to keep them involved and motivated towards the company, the companies go an extra mile to reward them by giving them sweat equity/ESOPs.

Sweat Equity Shares

According to Sweat Equity Shares under Companies Act, 2013 it means that such equity shares as are 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 values addition, by whatever name called.

Definition of an ‘employee’

Companies (Shares Capital and Debenture) Rules, 2014 defines the term ‘Employee’ as an employee who has become permanent and who has been working in India or outside India for at least one year or a director of the company who may be a whole-time director or part, or an employee or a director mentioned before in India or outside India or of a holding company or subsidiary.

Legal Framework governing Sweat Equity Shares

Section 2(88) of Companies Act, 2013 defines sweat equity share as the equity shares issued by a company to its directors or employees at a discount or for consideration other than cash, for providing their know-how or in the nature of Intellectual property or value addition to the company.

Rule 8 of the Companies (Share Capital and Debenture) Rules, 2014 define employee as:

1. A permanent employee of the company who has been working in or outside India for a period of at least one year;
2. A director of the company, it can be a whole time director or any other director;
3. An employee or director working in the holding company or subsidiary of a company.

Section 54 of the Companies Act, 2013 provides for the issue of sweat equity shares subject to fulfillment of following conditions:

1. Sweat Equity issues should be authorized by a special resolution.
2. The resolution should contain information about the number of shares, current market value of the shares, consideration and to the class of employees or directors to whom the shares are being issued.
3. The special resolution has to act within 12 months of passing otherwise it will be rendered invalid and a fresh resolution has to be passed again.
4. Sweat Equity shares shall be issued in accordance with the SEBI regulations.
5. The rights, limitations, restrictions and provisions which are applicable to equity shares shall also be applicable to sweat equity shares. 
6. The sweat equity shares which are issued to directors and employees shall be locked in and is non-transferable for a period of three years. The non-transferability of the shares shall be mentioned in bold on the share certificate.

Value Addition

‘Value Addition’ means actual or anticipated economic benefits derived or to be derived by the company from an expert or a professional for providing know-how or making available rights in the nature of intellectual property rights, by such a person to whom sweat equity is issued. 

Quantum of Sweat Equity Shares

Rule 8 of Companies (Share Capital and Debenture) Rules, 2014 provides that a company shall not issue sweat equity shares for more than 15% of the existing paid-up equity share capital or shares of the value of 5 crores, whichever is higher and it cannot exceed 25% of the paid-up equity capital of the company. Startups may issue sweat equity shares upto 50% of its paid-up share capital upto 5 years from the date of incorporation.

Valuation of Sweat Equity Shares

The sweat equity shares to be issued shall be valued at a price determined by the registered valuer as a fair price. The registered valuer is also required to give justification for determining the fair price. A registered valuer has to be appointed for the valuation of intellectual property rights or of know-how or value additions for issuing sweat equity shares. A report will be submitted by the valuer to the board of directors along with justification for such valuation. The gist of the critical elements of the report will also be sent to the shareholders.

Procedure to Issue Sweat Equity Shares

Rule 8 of Companies (Share Capital and Debenture) Rules, 2014 provides for the procedure of issuing of sweat equity shares.

Directors’ Disclosure Report

A directors’ report is the financial report which is required to be filed at the end of the financial year. A true and correct representation of the issue of sweat equity shares shall be given to the shareholders. It will contain the following details in the report:

1. The class of Director or employee to whom sweat equity shares were issued; 
2. The class of shares issued as sweat equity;
3. Number of sweat equity shares issued to the Directors, KMP or other employees showing separately the number of such shares  issued to them for consideration other than cash and the individual names of the allottees holding one percent or more of the issued share capital;
4. Proper Justification for the issue;
5. The terms and conditions for the issue of sweat equity shares, including price formula;
6. The total number of sweat equity shares arising as a result of the issue;
7. The total percentage of sweat equity shares of the total post issued and paid-up share capital;
8. Benefit received by the company after the issue of Sweat Equity;
9. The diluted Earnings per Share (EPS) pursuant to the issue of sweat equity shares.

Accounting Treatment of Sweat Equity

• When the sweat equity is issued for non-cash consideration based on the valuation report by the registered valuer then such it shall be treated in the following manner:

1. Where the non-cash consideration takes the form of depreciable or amortizable asset, then it will be treated in the balance sheet of the company in accordance with the applicable accounting standards; or
2. Where clause (1) is not applicable then it shall be treated as expense as per the relevant accounting standards.

•  The sweat equity shares issued will be treated as part of managerial remuneration if the following conditions are satisfied:

1. Sweat equity shares are issued to any directors or managers;
2. If the sweat equity shares are issued for consideration other than cash and are not in the form of assets which can be carried to the balance sheet then it shall be treated by applicable accounting standards.

• If the sweat equity shares issued during an accounting period, then the value of the sweat shares shall be calculated as a form of compensation to the employee in the financial statements, if the equity shares are not purchased pursuant to the acquisition of an asset.
• If the sweat equity shares are issued after the acquisition of an asset then the value of the asset will calculated as per the valuation report, shall be carried it in the balance sheet as per the accounting standards and amount of the accounting value of the sweat equity that are in the excess value of the asset as per the valuation report, shall be treated as compensation to the employee or director of the company.

Why Startups offer Sweat Equity Shares?

Startups in their initial stages do not have adequate resources or capital to compensate employees for their hard work. At the same time it is very important for startups to retain very high-quality human resources.  Startups can benefit a lot by issuing sweat equity shares to the employees to compensate for the contribution towards the growth of the company. This type of business model is vital for the long term development of startups. 

Startups can issue shares up to 50% of its paid-up share capital within 5 years from its incorporation and this can be utilized in the most efficient manner by the employers by formulating a mechanism which can be beneficial to both employees and employers.

Reasons to issue sweat equity

1. Incentive for employees- It is very important to incentivize the employees in an appropriate manner for the long term growth of the company. Sweat equity acts as an incentive for their contribution and it motivates them to perform better. Startups usually do not have high capital and won’t be able to monetarily compensate the employees which might lead to unsatisfied employees. This might be a problem for the development and sustenance of the company. So it is very important to keep the employees content and issuing of sweat equity shares is one of the best business models which a company can adopt. If the company is doing well then the employee receives higher dividends. This is also a motivating factor for the employees and directors to perform better.
2. Retain best talents- When the sweat equity shares are issued to the employees it is locked for a period of three years. This will make the employee stay in the company for a longer duration and work in an efficient and effective manner. In most of the companies attrition rate is very high and it is very difficult to retain employees for a long period of time as employees tend to leave for better opportunities.
3. Cost-efficient method for companies- Sweat equity shares reduce the expenditure of the company as the employees who are supposed to be compensated monetarily are now getting compensated through equity shares. This reduces the expenditure of the company to a large extent. 
4. Participation by employees in the Company’s management- After receiving sweat equity shares, the employees will also become the owners of the company. The employees can voice their concerns to the top management and will be able to represent the operating part of the company. This will lead to informed decisions by the top management regarding operations and help in the long term growth of the company.
5. Tax Benefits- As per Income tax act, 1961 the employee is required to pay tax on the shares allotted to him. To determine whether sweat equity shares are taxable in the hands of employees it has to satisfy certain conditions and they are following:

• The security has to be a specified security or sweat equity as defined in section 2(h) of the Securities Contract (Regulation) Act, 1956;
• Shares should be allotted or transferred after 1st April 2009;
• It should be allotted by the employer or former employer;
• It should be allotted to an employee or former employee.

Conditions for issue of Sweat Equity Shares

Sweat Equity Shares are issued only when the following conditions are fulfilled namely:

1. A special resolution has to be passed by the company to issue sweat equity shares
2. The resolution has to specify the number of shares, the current market price and the class or classes of directors or employees to whom these equity shares are issued.
3. The sweat equity shares that are authorised by the special resolution shall be valid for making the allotment within a period which is not more than 12 months from the date of passing of the special resolution.
4. The company should at least be incorporated for one year.
5. In the case where the equity share of the company is listed in a stock exchange, the sweat equity shares are issued as per the Securities and Exchange Board and if it is not listed then the sweat equity shares are issued in as per the rules prescribed.
6. The sweat equity that is issued to directors or employees shall be locked in for a period of three years from the date of allotment of the shares and the share certificate is under lock-in and the period of expiry of lock-in shall be stamped in bold or mentioned prominently on the share certificate.  

Pricing of Sweat Equity Shares

The price of sweat equity shall be valued at a price determined by a registered valuer as for the fair price and providing justification for the valuation. The registered valuer shall be carried out the valuation of the know-how or the intellectual property rights or value addition for the sweat equity that has to be issued and he shall provide a proper report addressed to the board of directors with justification for the valuation. The gist along with critical elements of the valuation report that is obtained has to be sent to the shareholders with the notice of the general meeting.     

Sweat Equity for Employees

There are companies who issue sweat equity as an incentive or a bonus to their employees to keep up the hard work as well as add to the business value of the company. This gives an entrepreneurial vibe to the employee as they get rewarded multiple times once the company scales higher and the valuation of it increases.  

From the Employer’s point of view, providing sweat equity is not only an effective but it is also an effort made by the employer to keep the employee faithful to the company as the sweat equity shares allotted as sweat equity gets locked in for a period of three years from the allotment. Although Sweat Equity is taxable as perquisites in the hand of employees under Income Tax Act, 1961. When it comes to an unlisted company valuation of shares will depend on the closing and opening market price on the date and in case of an unlisted company, that value of the share is by SEBI Registered (Cat-I) Merchant Banker.

As mentioned before a company is allowed to issue sweat equity only up to 15% of the existing paid up equity share capital in a year or shares of issue value of Rs. 5 crores whichever is higher. It should not exceed 25% of the paid-up equity capital of the company at any point in time. There is an exception provided to the start-up company at any time where the sweat equity issued shall not exceed 50% of their paid-up capital up to 5 years from the date of its incorporation.

Sweat Equity in Startup Companies

Start-Up companies are mushrooming everywhere and at their nascent and uncertain state, their major concerns are of employee retention levels. Therefore, employers come up with ways to create attractive compensation packages structured to target highly dexterous workforce. Sweat Equity is one of the methods of attracting and motivating as well as pay high salaries the employees.

Employee stock options (ESOP) and sweat equity have been ways for incentives and bonuses which is very much popular among start-up companies and firms. It is profitable for employees as stock options permit to gain ownership in the company’s business which will also involve the employees to be more responsible towards their actions for the rise and fall of its financial condition.

Whereas for founders as well as for institutional investors consider stock options or sweat equity as dilution of their shareholding pattern. Other than the stock option with a crucial funding event or reaching a key milestone when it comes to revenue, it is essential. The employers formulate this mechanism by offering to employee or directors at a discounted rate instead of cash based on their work, value additions provided and intellectual strides made.

Although such allocations are negotiable but are it possible to entirely pay the salary in form of sweat equity? This has raised a question in the minds of several start-up companies.

As mentioned before that the limit of sweat equity for start-up could be raised 50% of the paid-up capital. As per Income Tax Act, 1961, the value of sweat equity shares are taxable in the hands of the employee in the year in which the shares are allotted or transferred to the employee. In order for it to come under Income Tax Act, 1961 tax allotment of the sweat equity shares can be evaluated by:

1. The securities of shares that are involved are of Specified Securities or Shares that is defined under Section 2(h) of the Securities Contract(Regulation) Act, 1956
2. Sweat Equity shares that are allotted or transferred on or after April 1, 2009
3. Sweat Equity Shares are allotted by the employer or former employer to the employee.
4. Sweat Equity may be transferred to the employee or former employee, directly or indirectly.  

If the above conditions are satisfied then perquisites will be taxable as “Salary” in the hands of an employee in the assessment year relevant to the previous year in which shares or securities are allotted or transferred to the employee. These valuations can be done on Fair Market Value of securities at the date of exercise of the option by the employee.

Key Concepts to keep in mind while granting Sweat Equity Shares to employees by Startups

• Granting of sweat equity shares- While deciding the granting of sweat equity to employees the directors and founders of the firm should select the right employees. The company should reward only those employees who have long term goals with the company and are firmly dedicated for the development and welfare of the company. 
• Right skills and expertise- Employees who cannot be compensated monetarily for their contribution to the company should be selected for sweat equity shares. It is very important for the company to identify the employees who possess valuable skills and expertise that will benefit the company. 
• Valuation of sweat equity shares- Most of the startups are a private limited company and the valuation of the sweat equity share is done by a registered valuer. It is very difficult to ascertain the value of shares in numerical terms and also it is important to understand the contribution of employees for the expansion of the company. Proper justification and valuation should be taken into account before granting sweat equity shares. 

Conclusion

Thus, there are limitations that have to be kept in the mind when a salary is given in terms of sweat equity, that is the limit of sweat equity for a startup could only be up till 50% of the paid-up capital. Thus, practically speaking, if the number of employees is more and all of them are paid only through sweat equity then there are chances that it might exceed 50% of the paid-up capital. But considering if the situation arises where the employees can be entirely paid through sweat equity and the limit does not exceed 50% then it is acceptable if the employees accept such condition. Sweat Equity is considered to be a “Salary” and it is also taxable under Income Tax Act, 1961. Therefore, if the employer wants to pay its employees only through sweat equity then such deals are acceptable if the restricted limits are followed.  

Another threat that has been haunting the founders of losing their ownership in the company or imagining that retaining the percentage of shareholding and also raising third-party funding and sharing at the same time is a difficult task, was the question that needed an answer. As the position currently stands to limit of an issue of sweat equity at 50% of the paid-up capital which has liberalised the issue of the sweat equity shares. This provides a way to the founders to better structure their cap and have control over the shareholdings in the Company.  

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