Sweat Equity

THE IPL ROW HAS BROUGHT THE CONCEPT OF ‘SWEAT EQUITY’ INTO FOCUS. 

Sweat equity, very literally put, are equity shares that the company issues to an individual in consideration of his services, knowhow or any other value addition that the company has benefited from. 

What is sweat equity? 

Sweat equity refers to shares given to a company’s employees or directors on favourable terms in recognition of their work. These shares are issued to employees or directors at a discount or for a consideration other than cash for providing knowhow, making available rights in the nature of intellectual property rights or value additions. 

Are “sweat equity” the same as “stock options”?

Not exactly. They are similar to the extent that both are means of providing non-cash incentive or compensation to individuals. However, sweat equity, as widely understood, are real shares allotted to individuals upfront.

Stock options, on the other hand, is merely a right given to the individual to acquire shares of the company at a future date at a pre-agreed price.

Cognisant of the inherent differences between the two, the Securities and Exchange Board of India (SEBI) has issued separate guidelines for sweat equity and stock options.

These guidelines are applicable to all Indian listed companies.

To whom can sweat equity be issued?

In a broader sense, sweat equity can be issued to anyone who has rendered services to the company. Sweat equity can be issued to an employee, consultant or a vendor. That is the reason start-up companies use sweat equity as currency to pay for services that they cannot pay for in “hard” cash.

However, in India, as per SEBI and DCA regulations, sweat equity shares can be issued only to employees or directors.

Why is sweat equity issued? 

The idea behind issuing sweat equity is to retain your best employees. There is no limit to the discount on share price that can be offered. Sweat equity makes employees part owners of the company and gives them a share of profits earned. 

Why would an employee or any other person accept shares instead of cash, especially from a start-up company whose future prospects are uncertain?

The whole concept of using company shares as remuneration or reward has its origins in the famous Silicon Valley. Employees and vendors joined together to build an ecosystem that allowed technology start-ups to access talented resources and high quality services in return for company stock. Many of these start-ups are Fortune 100 companies and many of these employees who took stock instead of cash are millionaires, if not billionaires.

At the same time, all start-ups do not go on to become a Microsoft or HP. If the company fails, the stocks are worthless and that is the risk-reward judgment an individual has to grapple with.

Is there any limit to the amount of sweat equity? 

The sweat equity issued during a year should not exceed 15% of the total paid-up capital of the company or a value of Rs 5 crore, whichever is higher. The company needs to get prior approval of the central government to go beyond this level. It is also restricted from issuing sweat equity before completing one year of incorporation. 

Guidelines for sweat equity shares in case of unlisted companies?

Sweat equity is governed by Section 79A of the Companies Act. To regulate sweat equity in case of unlisted companies, the Department of Company Affairs (DCA) has issued the “Unlisted Companies (Issue of Sweat Equity Shares) Rules, 2003”.

Who determines the value of sweat equity? 

The price of sweat equity shall be determined by an independent valuer. If shares are issued for a consideration other than cash, the valuation of intellectual property or know-how shall be carried out by a valuer. Such valuer shall consult experts considering the nature of the industry and the value addition. 

What steps do a company need to take? 

The issue of sweat equity shares should be approved by shareholders by means of a special resolution at a general meeting or an extra-ordinary general meeting of a company. The explanatory statement accompanying the notice of the general meeting should include reasons and justifications for such the sweat equity issue, value of such shares, the valuation report and other details.

Sources: Economic Times, HinduBusinessline, Financial Express, Google