What are Sweat Equity Shares & How Do They Work?

Sweat equity shares are issued by a company to its employees or directors at a discount or for a consideration other than cash. It gives the company directors or employees ownership and equity upside in the company.

In India, sweat equity shares are issued according to the Companies Act, 2013 and Companies (Share Capital and Debentures) Rules, 2014. For listed companies, the Securities Exchange Board has laid down the rules regarding the issuance of these shares.

Unlike ESOPs, the sweat equity shares are allocated immediately. Sweat equity shares are generally given to the employees or directors for their:

• Extraordinary contribution and hard work in the completion of a project.
• Technical know-how or expertise in an area of the business.
• Value addition made to the company or contribution towards gaining intellectual property rights.

The key benefits of sweat equity for companies are:

• Saves cash: Offering sweat equity as a reward saves cash for the issuing company. It is beneficial for cash-strapped businesses; offering equity as compensation reduces the cash expenses.
• Provide Upside & Retain employees: Sweat equity creates a generous reward for the employees and makes them feel valued. It imbibes a sense of ownership and responsibility in them, helping to retain talent for the company.

Some considerations for founders and employees with sweat equity:

• Lock-in period: A lock-in period of 3 years may not be agreeable to all the employees/directors.
• No vesting period: Founders may prefer to have a vesting period, while providing equity upside else there is a risk of employees leaving the company with shares in hand.
• Upfront tax implications in the hands of an employee: Employees may need to pay tax upon receiving the sweat equity shares.

Eligibility for Sweat Equity Shares:

The followings are eligible to get sweat equity shares:

• Permanent employee of the company who is working with the company for at least 1 year in India or abroad.
• Permanent employee of the subsidiary company or a holding company working either in India or abroad for at least 1 year.
• Directors of the company (independent directors are not eligible)

Conditions for Issuing Sweat Equity Shares

Listed companies must issue sweat equity shares in accordance with Companies (Share Capital and Debentures) Rules, 2014 by SEBI, while unlisted companies must issue sweat equity shares according to section 54 of the Companies Act, 2013.

Following are the conditions that company must fulfill to qualify for issuing sweat equity shares:

• A special resolution shall be passed for authorizing the allocation of sweat equity shares.
• The shares can be issued only after 1 year of the commencement of the company.
• The company shall not issue sweat equity shares for more than 15% of the existing paid-up equity share capital in a year or shares of the issue value of rupees 5 crores, whichever is higher, provided—the issuance of sweat equity shares in the company shall not exceed 25% of the paid-up equity capital of the company at any time
• The price of shares needs to be valued by a registered value for unlisted companies.

Procedure for Issuance of Sweat Equity:

Following is the step-by-step procedure for issuing sweat equity shares:

• Step 1: Companies need to call a board meeting for sweat equity shares issuance, with at least 7 days notice.
• Step 2: The board notice needs to be annexed with an explanatory statement which shall contain the details, such as date of the board meeting, reasons for sweat equity issue, class of shares to be issued, the total number of shares to be issued, class of employees/directors to whom sweat equity shares are proposed to be issued, the price at which shares are issued and terms and conditions for issuing.
• Step 3: In the board meeting, the proposal needs to be passed with a special resolution with approval from at least 3/4th members.
• Step 4: Within 30 days of passing the resolution, file form MGT-14 with the Registrar intimating the passing of the resolution.
• Step 5: After the resolution is filed, call the next board meeting to allot the shares.
• Step 6: Within 30 days of passing the board resolution for allotment of shares, file form PAS-3 with the Registrar.
• Step 7: The company shall maintain the register after allotment of shares in form SH-3 with all the details & particulars of Sweat equity shares.

Disclosure After Allotment of Sweat Equity

The company shall disclose the following details in the annual board report for the year in which sweat equity shares were issued:

• Class of employees/directors to whom shares were issued
• Class of issued shares
• Total numbers of shares issued to directors and employees
• Bifurcation of shares issued for cash and non-cash consideration
• Reason for the issuance of sweat equity shares
• Pricing formula used and the terms & conditions under which it is issued
• Percentage of the sweat equity shares of the total post-issue capital
• Diluted earnings per share (EPS)

How Sweat Equity Differs from ESOP

Startups mostly give ESOPs instead of sweat equity to employees in order to reward and retain them since there is a vesting period in ESOPs schemes. In contrast, sweat equity shares are allocated with immediate effect.

Let’s see some of the differences between sweat equity and ESOPs below.