Sweat Equity Shares: Meaning, Example, Lock-In Period & More

Imagine you are working in a small startup. The team is passionate. Everyone works with passion, be it day or night. All have the same goal to make the company one of the best in the industry.

One day, the founder gathers everyone for an important announcement. Instead of just offering a paycheck, they propose something different: sweat equity shares. That is definitely a great move, but what are sweat equity shares? 

While most have heard of equity and preference shares, this category is known to quite a few. One thing is sure: this is an opportunity for every employee to get their hard work recognized. But, well, there is more to it. So, if you are also looking for sweat equity shares meaning, read this guide here. 

What is Sweat Equity Shares?

Sweat equity shares are comparatively new and known to quite a few people. These are the shares that are issued to company employees. These shares compensate for their significant non-monetary contributions, such as skills, expertise, or intellectual property. 

These shares are usually offered in exchange for non-cash considerations and represent the value added to the company through the individual's efforts. Such shares serve as a strong motivator for employees and are a key factor in promoting employee retention.

This is mainly seen with startups and growing businesses. Since cash flow is limited, offering sweat equity shares becomes a great option for companies. This way, they can reward employees without any financial strain, creating a win-win situation for both.

How Sweat Equity Works?

The issue of sweat equity shares is done to the company's employees. This is quite clear. Now, it is important to understand how this works. So, let us understand this in simple terms with an example here.

Certain steps must be followed when a company decides on the issue of sweat equity shares. Everything needs to be considered, from analysing the people to offer during the vesting period. So, here are the steps that are followed:

1. Identifying Contributions

Companies identify employees, directors, or consultants who contribute significantly through skills, innovation, or performance. This includes developing new products, improving processes, driving revenue, or enhancing brand value. Sweat equity isn't limited to innovators; even regular employees creating long-term impact can be eligible.

2. Valuation 

Once the identification is done, the company needs to go for valuation. It should be based on the current financial standing. This is to ensure transparency and fairness. Here, the share price is also decided. 

3. Board Approval

Once the valuation is done, a proposal is made. This has to be approved by the board. Sometimes, this is even presented in the shareholder meeting as well. Approval ensures that everything is known and that things are streamlined.

4. Issuance of Shares

Once approved, the company issues the shares to eligible employees at a predetermined price, usually lower than the market value. This allows employees to gain ownership of the company.

5. Vesting and Lock-in Period

Sweat equity shares come with a vesting schedule. This means that employees earn their shares over time. There might also be a lock-in period when employees cannot sell their shares.

Sweat Equity Example

Understanding sweat equity shares with an example helps you to understand how this is implemented. 

Consider an Indian fintech startup, Company ABC, which has been growing for two years, with the founder contributing expertise and time worth Rs. 80 lakh without taking a salary. Now, a venture capitalist (VC) invests Rs. 8 crore for a 25% stake, valuing the company at Rs. 32 crore post-money. 

This means the founder’s 75% stake is now worth Rs. 24 crore without any direct monetary investment, purely due to sweat equity. This is common in Indian startups like Zomato, Paytm, and Nykaa, where the founders’ ownership gains massive value after external funding.

Rules and Regulations for Issue of Sweat Equity Shares

Now that you know what sweat equity shares are, let us quickly understand the regulations linked to the issue of sweat equity shares

In addition to this, the conditions that need to be fulfilled are:

1. Special Resolution Approval: The company must secure approval through a special resolution, endorsed by at least three-quarters (3/4th) of its members.

2. Timing of Allotment: Sweat equity shares must be allotted within 12 months from the special resolution's passing date.

3. Resolution Details: The special resolution must specify key details such as the number of shares, consideration price, current market price, and the beneficiaries like employees and directors.

4. Regulatory Compliance:

   a) Listed companies must adhere to the SEBI Regulation, 2002.

   b) Unlisted companies must follow the rules stipulated in Section 54(1)(d) of the Companies Act.

5. Company Existence: The company must have been in existence for a minimum of one year before the issuance.

6. Valuation Justification: The company must provide a comprehensive justification for the valuation of sweat equity shares.

7. Lock-in Period: The allotted sweat equity shares are subject to a lock-in period of three years from the date of allotment.

These conditions ensure that the issuance of sweat equity shares is conducted fairly and regulated, maintaining the integrity of corporate governance.

Eligibility Criteria for Sweat Equity Shares

The sweat equity shares are issued to employees to recognize their contribution. The eligibility is defined under Section 54 of the Companies Act 2013. The criteria are as follows: 

• Permanent Employees: Must be permanent employees of the company who have worked for at least one year, either in India or abroad.

• Directors: Any company director, regardless of whether they hold a full-time position.

• Holding/Subsidiary Company Staff: Any subsidiary or holding company employee and directors are also eligible.

• Special Resolution: The issuance must be authorized by a special resolution passed in a general meeting.

• Time Requirement: At least one year must have elapsed since the company commenced its business before issuing sweat equity shares.

ESOP vs Sweat Equity: Key Differences

Understanding the difference between ESOP and sweat equity is important. It helps you to understand what each of these means in your financial standing when offered. So, the points of difference are as follows:

Lock-in Period for Sweat Equity Shares

Sweat equity shares are subject to a mandatory lock-in period of three years from the date of allotment. This requirement, stipulated under Section 54 of the Companies Act, 2013, ensures that recipients, such as employees and directors, remain committed to the company during this critical phase. 

The lock-in period is designed to align their interests with the company's long-term success, preventing them from selling or transferring their shares prematurely. This arrangement fosters loyalty and encourages contributors to invest their efforts in driving the company’s growth.

How is Sweat Equity Calculated or Defined?

The conditions for the issue of sweat equity shares are quite clear. However, various aspects define the proper calculation of the same. The calculation of sweat equity typically involves assessing the value of the work contributed compared to monetary investments made by other stakeholders.

The key methods that are adopted for the calculation are as follows:

• Hourly Rate Method: Here, an hourly rate for the work is assigned first. Then, based on the hours of work, the total value for equity is obtained and allotted.

• Market Value of Services: The fair value of sweat equity shares is determined based on the market price. It includes the quoted shares and various valuation methods for unquoted shares. Some of the common ones are Discounted Cash Flow (DCF) and Comparable Company Analysis (CCA). This ensures accurate compensation for contributions made by employees or directors.

• Opportunity Cost: This is where the amount is calculated based on work done. So, if the employee worked somewhere else, the amount that he could earn there is considered over here. 

• Future Earnings Potential: Based on the potential profit expectation, here the calculation is done. So, based on this future earning potential, the current day equity value is based on. 

Additionally, the total issuance of sweat equity shares cannot exceed 25% of the company's paid-up capital at any time.

Example

For instance, consider a tech startup. A software developer contributes 200 hours to develop a new application. Say, the market rate for such development work is Rs 1,000 per hour.

The sweat equity calculated would be:

Sweat Equity Value = 200 hours × Rs 1,000/hour = Rs 2,00,000

This is what the value is and the developer will get shares in equal value.

Tax Implications of Sweat Equity Shares

The taxability in the case of sweat equity arises on various conditions. These act as the baseline for the holder and guide them on when and how to pay the taxes. Here are the key points that you must know when it comes to taxation:

Tax Implications for Contributors

In India, contributors receiving sweat equity shares are taxed as perquisites at the time of allotment based on the shares' fair market value (FMV). This value is added to their taxable income. When the shares are sold, any gains are subject to capital gains tax, classified as short-term if sold within 12 months and long-term thereafter. Furthermore, the contributors may be eligible for tax deductions on the expenses related to their sweat equity. Contributors must accurately report these transactions in their income tax returns.

Tax Implications for Companies

For companies issuing sweat equity shares, the fair market value (FMV) of the shares can be deducted as a business expense, reducing taxable income. Companies must comply with tax authorities' valuation guidelines to avoid penalties. Additionally, they must adhere to regulatory requirements under the Companies Act regarding the issuance of sweat equity, including proper documentation and disclosures related to the allotment process.

What are the Benefits of Sweat Equity?

Sweat equity shares meaning is now clear. But there is more to it. Why should a company be issuing it? Well, these are some of the main benefits of issuing sweat equity shares:

1. Cost Savings

Start-ups usually need to save cash as they need it to fund their operations. Here, the company can compensate employees with ownership stakes instead of immediate salaries or bonuses. This allows companies to allocate financial resources more efficiently during critical growth phases.

2. Attracting Talent

Sweat equity can help in talent retention. This is used to give recognition to hard work. A person getting this would feel valued and will be motivated to stay in the company for the long run. Also, since you offer them ownership, their desire to work harder is boosted. 

3. Employee Motivation and Retention

When you offer sweat equity shares, there is ownership. This brings in responsibility as well. This makes the aims of the company and its employees aligned in the same line. This interest encourages long-term commitment and reduces employee turnover.

4. Recognition of Contributions

Sweat equity acknowledges the hard work and dedication of employees. This is rewarding them for their efforts and expertise. This recognition can enhance job satisfaction and loyalty.

5. Alignment of Interests

By granting equity, companies ensure that employees have a vested interest in the organization's performance, promoting teamwork and collaboration toward common goals.

Limitations or Risks of Sweat Equity Shares

Sweat equity shares are great in various ways. But just like a coin has two sides, the same is the case here. There are a few risks that you should know, which are:

1. Performance Risk

The value of sweat equity shares is directly tied to the company's performance. If the company struggles or fails to meet its growth targets, the share value may decline, posing a risk of financial loss for recipients.

2. Reduced Ownership

Issuing sweat equity shares increases the total number of shares, leading to the dilution of existing shareholders' ownership. This can impact investor stakes and voting powers

3. Liquidity Issues

Sweat equity comes with liquidity problems. This comes with lock-in periods or restrictions on transferring shares. This limitation restricts them from selling off their shares when they need funds, which can be a concern. 

4. Legal and Compliance Issues

Managing sweat equity is not an easy task. Everything needs to be managed properly. A single mistake can lead to various legal and compliance issues. This can damage the image of the company.

5. Valuation Challenges

Accurately valuing sweat equity can be difficult, leading to potential disagreements over share pricing and compensation fairness.

These factors highlight the need for careful planning and communication when implementing sweat equity arrangements.

Conclusion

Sweat equity shares are a great tool for the company. They help to reward the employees in the best possible manner. But there are some limitations as well. Hence, it becomes very important for the companies to understand them properly.

Knowing how to issue is not enough. You need to understand how to calculate and when to issue as well. Also, identifying the ones to issue the sweat equity shares is crucial too. So, follow the pointers shared in the guide here and prepare to maximize the advantages of sweat equity while mitigating associated risks.

FAQs

Q1: Is sweat equity legal in India?

Yes, sweat equity is legal in India. It is issued under the Companies Act.

Q2: What is the difference between sweat equity and normal equity?

Sweat equity is issued to employees or directors for their skills and work, while normal equity involves buying into the company with money.

Q3: Can sweat equity be revoked?

No, sweat equity cannot be revoked once issued. But since there is a lock-in period, it cannot be redeemed as well. 

Q4: Is there a limit on issuing sweat equity shares?

Yes, there is a limit to issuing sweat equity. A company can issue up to 15% of its paid-up capital or shares worth Rs 5 crores in a financial year, whichever is higher.

Q5: Are sweat equity shares transferable?

Sweat equity shares are generally non-transferable during the mandatory lock-in period of three years from the date of allotment.