What you need to know about sweat equity shares, their merits, and taxation?

You may have probably heard or read this a thousand times: finance is the lifeblood of a business. So are employees. Meaning they are critical to a business’ wellbeing as their efforts and hard work go a long way in its growth. That is why some companies reward their employees — in addition to paying remuneration — just to retain talented folks that contribute extraordinarily to the growth of the business.

One such way they do this is offer sweat equity share. Read what they mean, how they benefit the issuing company and employees, and recent developments in the space here.

What are sweat equity shares?
Section 2(88) of the Companies Act, 2013 defines ‘sweat equity shares’. Simply put, these are equity shares offered to select employees and directors of a company for their:

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

Further, sweat equity shares are issued either by way of discount or consideration other than cash. They allow employees/directors to participate in a part of the company’s profits as a return on their investment. Now that you know what are sweat equity shares, read the laws that govern these.

Which law governs the issue of sweat equity shares?
The issuance of sweat equity shares is governed by the Companies Act, 1956 and the Companies Act, 2013. In case of an unlisted company, the entity has to abide by Section 54 read along with The Companies (Share Capital and Debentures) Rules, 2014. And in case of a listed company, the entity has to comply with the SEBI Regulations besides the Companies Act, 2013.

Conditions applicable to the issue of sweat equity shares
Section 54 of the Company Act, 2013 lays down conditions that a company has to comply with while issuing sweat equity shares. They include:

• The company has to pass a special resolution with the approval of 3/4th members
• Sweat equity shares have to be allotted within the 12 months from the date when the special resolution was passed
• The special resolution has to mention details including the number of shares to be issued, consideration price, current market price, and employees and class of directors
• In case the entity is a listed company, it has to abide by the SEBI Regulation, 2002 to issue sweat equity shares
• In case the entity is a non-listed company, it has to abide by the rules prescribed in Section 54(1)(d)
• The company has to be incorporated for at least a year
• The company has to furnish proper justification for the value of sweat equity shares
• The sweat equity shares are locked in for 3 yrs from the date of allotment

On meeting the above conditions and receiving the required approvals from the board and employees, the company can go ahead and make a private offer of sweat equity shares to the eligible employees.

Who can issue sweat equity shares?
Following companies can issue sweat equity shares:

• One person company
• Pubic company
• Private company
• Section 8 company
• Listed or unlisted company

Which employees are covered under the sweat equity shares scheme?
As per Section 2(88) of the Companies Act, 2013, employees covered under the scheme are:

• Directors or
• Employees

How does the law define employees?
As per Rule 8(1) of the Companies (Share Capital and Debentures) Rules, 2014, an “Employee” means:

• An individual who is a permanent employee of the company and has been working in or outside India for at least a year, OR
• A director of the company, regardless of being a whole-time director or not, OR
• An employee or a director as defined above of the entity’s holding or subsidiary company in or outside India

How is the value addition defined?
As per Rule 8(1) of the Companies (Share Capital and Debentures) Rules, 2014, “Value addition” means actual or anticipated economic benefits that are created by the employees or directors and are either derived or are yet to be derived by the company.

How many sweat equity shares can a company issue?
A company can issue sweat equity shares up to the higher of the following:

• 15% of its existing paid-up equity share capital in a year
• Equal to the value Rs 5 cr

Further, the sweat equity shares shouldn’t exceed 25% of the paid-up equity capital of the issuing company at any point in time. However, there is an exception for startups. They can issue sweat equity shares of up to 50% of the paid-up capital within 5 yrs from the date of registration or incorporation.

Valuation of sweat equity shares
A registered valuer is appointed to determine the value of the intellectual property rights/know-how/value additions created with respect to which the company is considering the issue of sweat equity shares. The fair price of such equity shares to be issued is ascertained by a registered valuer, who is also required to justify their valuation.

Significance of sweat equity shares
Now that you have read the legal part of sweat equity shares, understand how this type of equity is beneficial to the issuing company and employees/directors receiving them.

Start-ups being fairly new in the business may be cash-strapped and unable to offer monetary rewards to their deserving employees. Thus, offering sweat equity shares can come in handy. They can simply reward employees by issuing them sweat equity instead of paying in cash. Not only start-ups, but well-established companies can also enjoy this benefit

To the employees, sweat equity shares act as a reward for the sweat that they invest in a business and encourage them to stick with the company for longer
Sweat equity negates the need to raise funds by taking on debt
If an employee who has taken a pay cut in the initial days of the business, sweat equity shares make up for the loss they had faced earlier. Continue to read about the taxation of sweat equity shares, calculation of their fair market value in case of listed and unlisted shares, and how the recent amendment in the law came as a saviour to cash-strapped startups and businesses.