From Effort to Ownership: The Process of Issuing Sweat Equity Shares

INTRODUCTION

In today's competitive corporate landscape, companies are constantly looking for innovative ways to attract, retain, and motivate key personnel. One such mechanism is the issuance of Sweat Equity Shares, which allows companies to reward employees and directors for their contributions in the form of equity, rather than direct financial compensation. This not only fosters loyalty but also aligns the interests of the employees with the growth and success of the company.

WHAT ARE SWEAT EQUITY SHARES?

Sweat Equity Shares refer to shares issued by a company to its employees or directors at a discounted price or for consideration other than cash in exchange for their know-how, intellectual property, or other value additions to the company. These shares recognize the efforts and expertise contributed by individuals that directly enhance the company's profitability and operations.

LEGAL FRAMEWORK GOVERNING SWEAT EQUITY SHARES IN INDIA

In India, the issuance of Sweat Equity Shares is regulated by:

1. Section 54 of the Companies Act, 2013
2. Rule 8 of the Companies (Share Capital and Debentures) Rules, 2014
3. SEBI (Share Based Employee Benefits and Sweat Equity) Regulations, 2021 (for listed Companies)

ELIGIBILITY FOR ISSUING SWEAT EQUITY SHARES

As per Section 54(1) of the Companies Act, 2013, a company (whether Public or Private) can issue Sweat Equity Shares to:

• Permanent employees working in or outside India.
• Directors of the company (including whole-time and part-time directors but excluding independent directors).
• Employees or directors of subsidiaries, holding companies, or associate companies.

A startup company recognized by DPIIT can issue Sweat Equity Shares up to 10 years from the date of incorporation, whereas other companies are restricted to 5 years.

CONDITIONS FOR ISSUANCE OF SWEAT EQUITY SHARES

As per Rule 8 of the Companies (Share Capital and Debentures) Rules, 2014, the following conditions must be met:

Approval through a Special Resolution and disclosure in Explanatory Statement - A special resolution must be passed in a General Meeting, authorizing the issuance and Explanatory statement shall inter-alia include all the disclosure as specified under Rule 8 clause (2).

Lock-in Period - The shares issued under this scheme are subject to a mandatory lock-in period of Three Years as per Rule 8 Clause (5).

Valuation of Shares and Consideration -

• The Valuation certificate from Registered valuer and Merchant Banker to be obtained.

Limits on Issuance -

• A company cannot issue more than 15% of its paid-up capital or INR 5 Crores worth of Sweat Equity Shares in a year, whichever is higher.
• The total issuance over a lifetime should not exceed 25% of the paid-up capital.
• For startups, this limit is 50% of the paid-up capital for the first Ten Years.

Disclosure Requirements - The company must provide necessary disclosures in the Board's Report as set out in Rule 8 Clause (13), few of them are as under:

• Justification for issuance
• Number and class of shares issued
• Valuation report
• Impact on the company's finances and dilution of equity

PROCEDURE FOR ISSUING SWEAT EQUITY SHARES

The process of issuing Sweat Equity Shares involves multiple steps to ensure compliance with regulatory norms:

Step 1: Convene a Board Meeting

• Issue notice and agenda to directors.
• The Board of Directors must approve the proposal and schedule a General Meeting for shareholders' approval.
• The draft resolution, explanatory statement, and details of the valuation must be prepared.

Step 2: Shareholder Approval

• A Special Resolution must be passed in the general meeting with at least 75% approval from shareholders present and voting.
• The Explanatory Statement must include details as specified in Rule 8 Clause (2), few of them are listed below:
  • Number of shares
  • Class of persons to whom shares are issued
  • Price and basis of valuation
  • Lock-in period and justification

Step 3: Valuation and Pricing

• The price of the shares must be determined by a registered independent valuer and Merchant Banker.
• A report justifying the valuation and benefit to the company should be prepared.
• If issued against intellectual property or know-how, the asset valuation must also be done by a valuer.

Step 4: Issuance of Shares

• After shareholder approval and compliance with valuation norms, the company issues Sweat Equity Shares to eligible Employees or Directors.
• The shares are locked in for Three Years, and necessary entries are made in the company's records Register of Sweat Equity Shares in Form No. SH.3 and shall forthwith enter therein the particulars of Sweat Equity Shares issued.
• Issue share certificates within Two Months of allotment.

Step 5: Filing and Compliance

• File Form PAS-3 (Return of Allotment) with the Registrar of Companies (ROC) within 30 days of issuance.
• Filing of E-Form MGT-14 for the Special resolution and advisable to file for Board Resolution also.
• Update the Register of Members and issue share certificates in Form SH-1.
• Maintain a Register of Sweat Equity Shares (SH-3).

TAX IMPLICATIONS

• For Employees - Sweat Equity Shares are considered perquisites under the Income Tax Act, 1961 and are taxable as Salary Income.
• For the Company - The company can claim the expenditure incurred as a deduction under the Income Tax Act.
• On Sale of Shares - The capital gains tax applies when the employee sells the shares in the future.

BENEFITS OF ISSUING SWEAT EQUITY SHARES

• Employee Retention - Encourages long-term commitment by offering ownership stakes.
• Motivation and Productivity - Employees feel valued and are more motivated to contribute.
• Cash Conservation - Helps startups and cash-strapped companies reward talent without an immediate financial burden.
• Alignment of Interests - Employees become stakeholders, aligning their interests with company growth.

CHALLENGES AND RISKS INVOLVED

• Dilution of Equity - Issuing shares may dilute existing shareholders' stakes.
• Valuation Complexity - Determining the fair value of contributions can be subjective.
• Regulatory Compliance - Non-compliance with SEBI or Companies Act regulations can lead to penalties.
• Lock-in Restrictions - Employees may find the three-year lock-in period restrictive.

CONCLUSION

Sweat Equity Shares serve as an effective tool for companies to recognize and reward key employees while fostering long-term commitment and alignment with business objectives. However, careful planning, valuation, and adherence to legal requirements are essential to ensure smooth execution. With the right approach, Sweat Equity Shares can be a win-win strategy for both companies and employees, promoting innovation and sustainable growth.

Disclaimer: This article provides general information existing at the time of preparation and we take no responsibility to update it with the subsequent changes in the law. The article is intended as a news update and Affluence Advisory neither assumes nor accepts any responsibility for any loss arising to any person acting or refraining from acting as a result of any material contained in this article. It is recommended that professional advice be taken based on specific facts and circumstances. This article does not substitute the need to refer to the original pronouncement.