Sweat Equity Shares: What They Are and How They Work

What are sweat equity shares?

According to Section 2(88) of the Companies Act, 2013, sweat equity shares are equity shares issued to a company’s directors or employees at a discount or for non-cash considerations like: 

• intellectual property or technical skills
• strategic advice or leadership
• product development or innovation
• business growth and sales efforts

For example: A tech startup developing an AI-driven financial tool needs a machine learning expert but lacks the funds to hire one. Instead, it offers the expert 2% sweat equity in exchange for their expertise. As the company grows, the shares appreciate, potentially becoming a significant payout if the startup is acquired or goes public.

How to issue sweat equity shares in India?

In India, the issuance of sweat equity shares is regulated by Section 54 of the Companies Act, 2013, along with Rule 8 of the Companies (Share Capital and Debentures) Rules, 2014, and SEBI regulations for listed companies.

Below is the process for issuing sweat equity shares.

1. Check eligibility

A company can issue sweat equity shares if:

a. It has been in existence for at least one year.

b. It is issuing shares to directors or employees for their contribution.

c. In a single year, the total sweat equity issued does not exceed 15% of paid-up equity share capital or ₹5 crore, whichever is higher.

d. At any point in time, the total issued sweat equity does not exceed 25% of paid-up equity share capital.

e. However, startup companies (as per the DPIIT definition) can issue sweat equity up to 50% of paid-up capital for the first five years after incorporation.

2. Board and shareholder approval

a. Hold a board meeting to approve the proposal for issuing sweat equity shares.

b. Fix the date and agenda for an Extraordinary General Meeting (EGM) to get shareholders’ approval.

c. Pass a special resolution in the EGM, specifying:

- The number of shares to be issued

- The class of employees/directors eligible

- The valuation method and current market price

- Consideration, if any

3. Valuation requirements

a. A registered valuer must determine the fair value of sweat equity shares and provide a justification report.

b. The value of intellectual property, know-how, or other benefits received by the company in return must also be determined.

4. Allotment of shares

a. Issue the sweat equity shares within 12 months of passing the special resolution.

b. File Form PAS-3 with the Registrar of Companies (ROC) within 30 days of allotment.

c. Maintain a register of sweat equity shares in Form SH-3.

5. Accounting treatment

If sweat equity is issued in exchange for non-cash consideration:

a. If the consideration is a depreciable or amortizable asset, it is recorded in the balance sheet.

b. In all other cases it shall be expensed and treated as part of managerial remuneration for directors/employees.

6. Disclosures

Companies issuing sweat equity must disclose the following details in the board’s report:
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a. The class of directors or employees who were given sweat equity shares.

b. The class of shares issued as sweat equity.

c. The number of sweat equity shares given to directors, key managerial personnel, or other employees, including the number issued for non-cash consideration and the names of anyone holding 1% or more of the total shares.

d. The reasons for issuing sweat equity shares.

e. The main terms and conditions of the sweat equity shares, including the pricing formula.

f. The total number of shares issued as sweat equity.

g. The percentage of sweat equity shares in relation to the total shares after issuance.

h. The consideration (including non-cash) or benefits the company received from issuing the shares.

i. The impact on Earnings Per Share (EPS) after issuing the sweat equity shares.

What is the lock-in period for sweat equity shares?

Sweat equity shares have a mandatory lock-in period of three years from the date of allotment. This restriction is prominently stamped on the share certificate.

Do sweat equity shares have the same rights as regular equity shares?

As per Section 54(2) of the Companies Act, 2013, sweat equity shares hold pari-passu rights, meaning they rank equally with other equity shares in terms of dividends and voting rights.

Who is eligible for sweat equity shares?

Under Rule 8(1) of the Companies (Share Capital and Debentures) Rules, 2014, sweat equity shares can be issued to:

a. Permanent employees working in India or abroad for at least one year

b. Directors of the company (whether full-time or not)

c. Employees or directors of subsidiaries or holding companies

ESOP vs sweat equity

Both ESOPs (employee stock option plans) and sweat equity shares are ways to offer equity to employees. 

However, ESOPs are generally not used to compensate for intellectual property, strategic advisory, product innovation, or business growth contributions due to key differences in their structure and purpose.

1. Purpose

ESOPs: ESOPs are designed to retain and motivate employees by offering them the option to buy company shares at a predetermined price after a vesting period, encouraging long-term commitment and contribution.

Sweat equity: Issued to compensate employees or directors for their past contributions, often when companies lack cash.

2. Eligibility

ESOPs: Available to employees only, excluding promoters and independent directors.

Sweat equity: Sweat equity can be issued to employees, whole-time or part-time directors, independent directors, and promoters with shareholder approval.

3. Nature of ownership

ESOPs: Employees don’t own shares immediately. They get the option to purchase shares after completing the vesting period.

Sweat equity: Shares are issued immediately, making the recipient a shareholder from the date of allotment.

4. Pricing and valuation

ESOPs: Employees buy shares at a pre-determined exercise price, which may be lower than market value.

Sweat equity: Shares are issued either at a discount or for non-cash consideration, often based on the value of contributions made.

5. Lock-in period

ESOPs: No mandatory lock-in, but they typically follow a vesting schedule, such as a four-year vesting period with a one-year cliff.

Sweat equity: A mandatory three-year lock-in period applies.

6. Company impact

ESOPs: No immediate dilution; dilution happens only when employees exercise their options.

Sweat equity: Causes immediate dilution since shares are issued upfront.