“Sweat Equity” shares mean equity shares issued by a company to its employees or directors at a discount or for consideration other than cash. In other words, it refers to the allotment of equity shares to employees as compensation for the efforts and hard work (aka sweat) in providing intangibles, like growth or success, for the company. The issuing of “sweat equity” allows the company to attract and retain its employees by rewarding them for their contribution.
Startups generally use ESOPs (Employee Stock Option Plan) rather than Sweat Equity to attract and reward employees. This is because, in the case of ESOPs, employees need not be allotted actual shares of the company till the time of exercise or a liquidity event, whereas, in the case of Sweat Equity, the shares are immediately allotted to the employee.
Significant differences between an ESOP Scheme & issue of Sweat Equity shares:
- Allotment: ESOP is a grant of options to employees to purchase shares in the future at a predetermined price. The shares are allotted to the employee only after the exercise of the ESOP grant. Sweat equity, on the other hand, is the direct allotment of shares at a discount or for consideration other than cash.
- Timelines: A company can issue sweat equity only after one year from the date of commencing business. There is no such restriction on the issue of ESOPs.
- Cliff & Lock-in: For ESOPs, there is a minimum period of one year between the grant and vesting of options. For Sweat Equity, there is a lock-in period of three years from the date of allotment of sweat equity shares. In contrast, there is no compulsory lock-in period for the allotment of equity shares under the ESOP scheme. For ESOPs, the company shall have the freedom to specify the lock-in period of the shares issued pursuant to the exercise of stock options.
- Who qualifies: The definition of employee is different for ESOPs and sweat equity shares- Sweat equity can be issued to a permanent employee of the company who has been working in India or outside India for at least the last year. No such restriction for the issue of ESOPs- ESOPs cannot be issued to an independent director, whereas sweat equity can be issued to an independent director- ESOPs cannot be issued to the promoters, a person belonging to the promoter group or to a director who either himself or through his relative or through any corporate body, directly or indirectly, holds more than 10% of the outstanding equity shares of the company. The only exception to this is for founders/promoters of DPIIT recognized startups where they are eligible to receive ESOPs for up to 10 years from the date of incorporation. This restriction does not apply to the issue of sweat equity.
- Dilution: The company cannot issue Sweat Equity for more than 15% of the existing paid-up equity share capital in a year or shares of the issue value of INR 5 crore, whichever is higher. Also, the issuance of Sweat Equity in the Company cannot exceed 25% of the paid-up equity capital of the company at any time. However, in the case of a Startup, the issuance of Sweat Equity shares cannot exceed 50% of its paid-up capital up to five years from the date of its incorporation or registration. These restrictions do not apply to the issue of equity shares under the ESOP scheme.
- Exercise: For ESOPs, companies have the freedom to determine the exercise price in conformity with the applicable accounting policies. For Sweat Equity, a registered valuer will determine the fair price for the shares and give justification for such a valuation.
- Consideration for the purchase of shares under the ESOP scheme can be done only in cash. However, a company can issue sweat equity shares to its employees at a discount or for a consideration other than cash.