All you need to know about Sweat Equity Shares

In this article, 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.

Value Addition

Value Addition is the actual or anticipatory economic benefits that are derived by the company from an expert/professional/employee for providing their know how or their intellectual property that belonged to them and this sweat equity is issued to them for which the consideration amount is not paid.

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.  

Quantum of Sweat Equity

Sweat Equity shall be issued only till 15% of the existing paid-up equity capital of the company in a year or shares of issue value of Rs. 5 crore, whichever is higher.

The issuance of sweat equity in the Company shall not exceed 25% of the paid-up equity capital of the Company at any time. In case of a start-up company, the issued sweat equity share should not increase more than 50% of its paid-up capital up to the period of 5 years from the date of its incorporation or registration.

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.

Procedure to issue Sweat Equity Shares

Firstly, summon and hold a board meeting in order to consider the proposal of issue of sweat equity shares and to fix up the date, time, place as well as the agenda for a general meeting and to pass a special resolution for the same.

Secondly, issue notices in writing to Shareholders for a general meeting along with explanatory statements. It should contain the following:

1. Date of the Board meeting at which the proposal for issue of sweat equity shares was approved;
2. The reason for the issue of shares
3. The class under which the shares are intended to be issued
4. The total number of shares that is to be issued as sweat equity
5. The class or classes of directors or employees to whom the shares are to be issues
6. The terms and condition on which the sweat equity shares are to be issued which also includes the basis of valuation.
7. The time period of association of such person with the company.
8. The name of the director or the employee to whom the sweat equity shares will be issued and their relationship with the promotor or/and Key Managerial Personnel.
9. The sweat equity share rate.
10. The consideration including consideration other than cash, if any.,
11. The ceiling on managerial remuneration, if any, be breached by the issuance of sweat equity and how it is proposed to be dealt with;
12. A statement to the effect that the company shall comply with the applicable accounting standards,
13. Diluted earnings per share pursuant to the issue of sweat equity shares which is calculated as per the applicable accounting standards,

Thirdly, Convene the general Meeting and Pass a special resolution.

Fourthly, file a resolution with MCA in Form No. MGT-14 within 30 days of passing the same.

Fifthly, call for the board meeting and allot sweat equity shares in the meeting.

Sixthly, Form No. PAS-3 had to be filed within 30 days of the passing of the Board resolution for allotting sweat equity.

Seventhly, Form No. SH-3 for the Register of Sweat Equity Shares shall be maintained and enter the particulates of Sweat Equity Shares.

Seventhly, a Sweat Equity Shares shall be maintained at the registered office of the company or any other registered office as the board decides.

Finally, the entries in the registrar shall be authenticated by the Company Secretary of the company or any other authorised person by the Board for the purpose.

Disclosure in the Director’s Report

The following details of the sweat equity are supposed to be disclosed in the Director’s Report for the year in which such shares are issued:

• Firstly, the class of directors or employee to whom sweat equity shares were issued;
• Secondly, the class of shares issued as Sweat Equity Shares;
• Thirdly, the number of sweat equity shares issued to the directors and the other employees as well as key managerial personnel showing the number of such shares issued to them for consideration other than cash and individual names of allotters holding one percent or more of the issued share capital.
• Fourthly, the reason has to be mentioned for the issue.
• Fifthly, the main terms and conditions for the issue of sweat equity shares, including pricing formula
• Sixthly, the total number of shares arising as a result of the issue of sweat equity shares and the percentage of the shares of the total post issued and paid up share capital.
• Seventhly, the amount received or benefit accrued to the company from the issue of sweat equity shares.
• Eighthly, the diluted Earnings per Share (EPS) to issuance sweat equity shares.

Accounting Treatment of the Sweat Equity Shares Issued

Firstly, the following performa has to be followed when the sweat equity shares are issued for a non-cash consideration on the basis of a valuation report in respect thereof gathered from the registered valuer-

1. Where the non-cash consideration takes the form of a depreciable or amortizable asset, it shall be carried to the balance sheet of the company as per the accounting standards; or
2. In cases where clause (1) is not applicable, it shall be expensed as per the accounting standards;

Secondly, the amount of sweat equity shares that are issued shall be treated as a part of managerial remuneration if the following condition is fulfilled namely:

1. The sweat equity shares are issued to any directors or managers;
2. If the consideration is not by a way of 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 standards.

Thirdly, the sweat equity that is issued as per the accounting period, the accounting value of the sweat equity shares shall be treated as a form of reimbursement to the employee or the director in the financial statements of the company, if the sweat equity shares are not issued pursuant to the attainment of an asset.

Fourthly, if the shares that are issued is in pursuant to the attainment of an asset, the value of the asset, that is determined  by the valuation report, shall be carried in the balance sheet according to the Accounting Standards and the amount of the accounting value of the sweat equity shares that are in excess of the value of the asset acquired as per the valuation report, shall be treated as a form of reimbursement of the employee or the director in the financial statement of the company.     

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.

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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