Having equity in a company is like having an ownership in the company. Sweat equity shares are the equity shares issued by the company only to their employees or directors for the hard work and sweat they put in for the company. In order to keep their employees motivated and involved, companies offer them ownership in the company by issuing them sweat equity for their efforts and labor. Companies are keen on retaining their best employees who bring their technical expertise and knowledge which enhances the value of the business. 

Sweat equity shares are defined in Section 2(88) of the Companies Act, 2013 (the “Act”) and are governed by section 54 of the Act and Rule 8 of The Companies (Shares and Debentures) Rules, 2014 (the “Rules”).

Sweat Equity Shares

Under the Indian law, sweat equity shares means “such equity shares as are issued by a company to its directors or employees at a discount or for consideration, other than cash, for providing their know-how or making available rights in the nature of intellectual property rights or value additions, by whatever name called.” [Section 2(88) of the Act]

Conditions for Issuing Sweat Equity Shares

Conditions to be satisfied by a company before issuing sweat equity shares:

• A special resolution shall be passed authorizing issue of such shares.
• Such special resolution shall specify number of shares, the current market price of such share, consideration, and the class or classes of directors / employees to whom such equity shares are to be issued.
•  Issue of such shares in a listed company shall be governed by the regulations made by the Securities Exchange Board of India in this behalf and in the case of an unlisted company shall be governed in accordance with such rules as may be prescribed i.e. The Companies (Shares and Debentures) Rules, 2014; [Section 54 of the Act] 
•  Mandatory conditions for Special Resolution: No unlisted company can issue sweat equity shares to its directors or employees at a discount or for consideration other than cash unless authorized by a special resolution by the company in general meeting. Such special resolution shall be valid for making the allotment within a period of not more than twelve months from the
  date of passing of the special resolution. Pursuant to Section 102 of the Act, it is mandatory to annex an explanatory statement to the notice of general meeting which shall enumerate the details of particulars mentioned in Rule 8(2) of the Rules. [Rule 8(1), 8(2) & 8(3) of the Rules]

Holders of sweat equity share shall be ranked on the same footing as with other equity shareholders. The rights, limitations, restrictions and provisions applicable to equity shares shall be applicable to the sweat equity shares issued

Amendment for facilitating startups in India: Ministry of Corporate Affairs, on 07 May 2018, notified the omission of a clause in Section 54 of the Act which results in removal of the restriction of taking into consideration the expiry of the time period of one year from the date of incorporation of the company for issuance of sweat equity shares by a company. This enables startups to issue sweat equity just after incorporation and retain talented employees. 
Employee for the purpose of Sweat Equity means and includes:

1. a permanent employee of the company who has been working in India or outside India, for at least last one year; or 
2. a director of the company, whether a whole time director or not; or 
3.  an employee or a director as defined in sub-clauses (a) or (b) above of a subsidiary, in India or outside India, or of a holding company of the company. [Explanation (i) to Rule 8(1) of the Rules]

​Value Addition under the Act means “actual or anticipated economic benefits derived or to be derived by the company from an expert or a professional for providing know-how or making available rights in the nature of intellectual property rights, by such person to whom sweat equity is being issued for which the consideration is not paid or included in the normal remuneration payable under the contract of employment, in the case of an employee.” [Explanation (ii) to Rule 8(1) of the Rules]

Quantum of Sweat Equity 

A company shall not issue more than 15% of the existing paid up equity share capital in a year for sweat equity or shares of the issue value of rupees 5 crores, whichever is higher, provided that the issuance of the sweat equity in the company shall not exceed 25% of paid up equity capital at any time. The sweat equity shares issued shall be locked in/non-transferable for a period of 3 years from the date of allotment. Share certificate in this regard shall include the period of lock-in. [Rule 8(4) & 8(5) of the Rules]
Exceptions for a Startup – A Startup which is recognized by the Government of India may issue sweat equity shares not exceeding 50% of its paid up capital up to five years from the date of its incorporation or registration.

Pricing of Sweat Equity

A registered valuer shall determine the price of sweat equity shares that are to be issued. The valuer shall submit a proper valuation report to the Board of directors giving justification for such valuation. The valuer for the purpose of valuation shall take into account intellectual property rights or of knows how or value additions for which sweat equity shares are to be issued. A copy of gist along with critical elements of the valuation report shall be sent to the shareholders with the notice of the general meeting. [Rule 6, 7 & 8 of the Rules]

Treatment of non-cash consideration

Where sweat equity shares are issued for a non-cash consideration on the basis of valuation report, such non-cash consideration will be treated in the books of the issuing company in the following manner:

1. where the non-cash consideration takes the form of a depreciable or amortizable asset, it shall be carried to the balance sheet of the company in accordance with the accounting standards; or
2. where clause (a) is not applicable, it shall be expensed as provided in the accounting standards. [Rule 9 of the Rules]

Accounting treatment of issued Sweat Equity

​Conditions to be satisfied for treating the amount of sweat equity shares issued as part of managerial remuneration for the purposes of profit calculations (Sections 197 and 198 of the Act):

1.  the sweat equity shares are issued to any director or manager; and 
2.  they are issued for consideration other than cash, which does not take the form of an asset which can be carried to the balance sheet of the company in accordance with the applicable accounting standards

If the shares are not issued pursuant to acquisition of an asset, in an accounting period, the accounting value of sweat equity shares shall be treated as a form of compensation to the employee or the director in the financial statements of the company;
If the shares are issued pursuant to acquisition of an asset, the value of the asset, as determined by the valuation report, shall be carried in the balance sheet as per the Accounting Standards and such amount of the accounting value of the sweat equity shares that is in excess of the value of the asset acquired, as per the valuation report, shall be treated as a form of compensation to the employee or the director in the financial statements of the company. 

Accounting value shall be the fair value of the sweat equity shares as determined by a registered valuer. [Rule 10, 11 & 12 of the Rules]

Disclosure in the Director’s Report

1.  the class of director or employee to whom sweat equity shares were issued.
2.  the class of shares issued as Sweat Equity Shares.
3. the number of sweat equity shares issued to the directors, key managerial personnel or other employees showing separately the number of such shares issued to them, if any, for consideration other than cash and the individual names of allottees holding one per cent or more of the issued share capital;
4.  the reasons or justification for the issue; 
5.  the principal terms and conditions for issue of sweat equity shares, including pricing formula
6.  the total number of shares arising as a result of issue of sweat equity shares; 
7. the percentage of the sweat equity shares of the total post issued and paid up share capital; 
8.  the consideration (including consideration other than cash) received or benefit accrued to the company from the issue of sweat equity shares; 
9.  the diluted Earnings Per Share (EPS) pursuant to issuance of sweat equity shares. [Rule 13 of the Rules]

A Register of Sweat Equity Shares in Form No. SH.3 shall be maintained by the company at the registered office or as decided by the Board of directors and shall forthwith enter therein the particulars of Sweat Equity Shares. The entries in the register shall be authenticated by the Company Secretary or as the case may be. [Rule 14 of the Rules]

Conclusion

Sweat Equity can only be issued to employees or directors of a company for providing their know-how or making available rights in the nature of intellectual property rights or value additions. However, through preferential allotment further shares may be issued (Section 62(1)(c) of the Companies Act, 2013) to advisors/consultants of the company who are not an employee or a director of the company.
The Companies (Amendment) Act, 2017 enables any startup company to issue sweat equity as soon as they are incorporated. Although, this is a bold move to facilitate startup initiative in India, it has its own drawbacks. There is a risk of startups giving up equity and losing ownership at the initial or the incorporation stage itself. In this scenario, the equity of startups will dilute early and that would be against the interest of directors. Losing ownership in the startup companies has been haunting founders because this reduces the chances of raising third party funding.

[ DISCLAIMER:  This article is for academic purpose and is solely to provide readers with general information regarding developments in Indian law. The information contained herein does not constitute legal or a professional advice. ]