Basics of Sweat Equity Shares as per Companies Act 2013

Whenever an investment is made in the financial market, the investor typically receives certain securities of the company in exchange for his money. Shareholders could subscribe to the corporation’s equity shares, preferential shares, or debentures. Equity is similar to owning a piece of a company.

‘Sweat Equity,’ in its broadest sense, is a contribution made to the project or business in the form of effort and labour. Sweat equity is worth the same as cash equity. Sweat equity is typically rewarded in the case of a company’s start-up by delivering securities or other kinds of shares in a new business.

The golden age is eager to retain their key staff who bring specialized knowledge, technical expertise, and domain competence that enhances the firm’s valuation. As a result, in hopes of keeping them invested and incentivized in the corporation, organisations go above and beyond by rewarding them with sweat equity/ESOPs.

Sweat Equity Shares

As per Sweat Equity Shares under Companies Act, 2013, Sweat Equity Shares are equity shares issued by a corporation to a director or staff at a reduced rate or for a consideration other than cash in exchange for delivering technical expertise or allocating assets such as intellectual property or quality enhancement.

Eligibility

The employee is defined under Rule 8 of the Companies (Share Capital and Debenture) Rules, 2014 as-

• Company employee on a permanent basis
• Employees who work full-time for a subsidiary or a holding company
• Director of the corporation

Conditions for issuing Sweat Equity Shares

Section 54 of the Companies Act of 2013 allows for the issuance of sweat equity shares if the following conditions are met:

• A special resolution should be passed to authorise Sweat Equity issues.
• The resolution should include information such as the number of shares issued, the current market value of the shares, the consideration, and the class of employees or directors to whom the shares are being issued.
• The special resolution must be implemented within 12 months of its passage or it will be declared invalid and a new resolution must be passed.
• Sweat Equity shares would be distributed in compliance with Sebi guidelines.
• The same privileges, restrictions, limitations, and requirements that apply to equity shares apply to sweat equity shares.
• Sweat equity shares released to directors and employees are locked in and non-transferable for a three-year period. The non-transferability of the shares must be highlighted on the share certificate.

Amount of Sweat Equity Shares to be issued:

According to Rule 8 of the Companies (Share Capital and Debenture) Rules, 2014, a company shall not issue sweat equity shares for more than 15% of its existing paid-up equity share capital or shares worth 5 crores, whichever is greater, and it shall not issue sweat equity shares for more than 25% of the company’s paid-up equity capital. Startups may issue sweat equity shares worth up to 50% of their paid-up share capital for a period of five years from the date of incorporation.

Pricing of Sweat Equity Shares 

The sweat equity shares to be issued must be valued at a fair price determined by the registered valuer. The registered valuer must also justify how they arrived at a reasonable price. For the valuation of intellectual property rights, know-how, or value additions for the purpose of issuing sweat equity shares, a registered valuer must be appointed. The valuer will submit a report to the board of directors, along with justification for such valuation. The gist of the report’s key points will also be distributed to shareholders.

Directors’s Disclosure Report

A directors’ report is a financial report that must be submitted at the end of each fiscal year. The shareholders must be given a good and accurate reflection of the issue of sweat equity shares. The report will include the following information:

• The type of Director or employee who received sweat equity shares.
• The type of stock issued as sweat equity.
• Quantity of sweat equity shares issued to the Board of Directors, KMP, or other employees, including the number of such shares issued for consideration other than cash.
• Reasoning for the problem.
• The terms of the agreement governing the issuance of sweat equity shares, along with the price formula.
• The estimated number of sweat equity shares that will be issued as a result of the issue.
• The total number of sweat equity shares as a percentage of total post-issued and paid-up share capital.
• The advantage garnered by the business as a result of the issuance of Sweat Equity;
• Earnings per share (EPS) diluted as a result of the issuance of sweat equity shares.

Advantages of Issuing Sweat Equity shares

• Employee rewards
• Preserve the top performers
• A cost-effective strategy for businesses
• Employee participation in the management of the company
• Tax Advantages

Final Words

Thus, when a salary is given in terms of sweat equity, there are limitations that must be kept in mind; for example, the threshold of sweat equity for a startup could only be up to 50% of the paid-up capital. Thus, in practical terms, if the amount of employees is greater and they are all paid solely through sweat equity, it is possible that it will exceed 50% of the paid-up capital. However, if a moment comes in which employees could be paid entirely via sweat equity and the threshold does not exceed 50%, it is appropriate if the employees embrace such a condition. Sweat equity is regarded as a “salary” and is therefore taxable under the Income Tax Act.

As a result, if the employer wishes to pay its employees solely through sweat equity, such agreements are permissible as long as the specified limits are met.

Another threat that had been haunting the founders was the fear of losing their ownership in the company or of imagining that retaining a percentage of shareholding while also raising third-party funding and sharing at the same time would be a difficult task. The current position limits the issue of sweat equity shares to 50% of the paid-up capital, which has liberalised the issue of sweat equity shares. This allows the founders to better structure their cap and maintain control over the Company’s shareholdings.