Articles

sweat-equity-risk-reward
Reference Date |  Version March 04, 2024 | 1.0
Keywords Sweat Equity Shares, compensation, valuation, Lock-in Period, Startups
Legislation(s)
  • The Companies Act, 2013
  • Companies (Share Capital and Debentures) Rules, 2014
  • Securities and Exchange Board of India (Issue of Capital and Disclosure Requirements) Regulations, 2018
  • Securities and Exchange Board of India (Share Based Employee Benefits and Sweat Equity) Regulations, 2021
Jurisdiction India

Introduction

The concept of ‘Sweat Equity’ was initially employed in the United States by Co-operatives for real estate projects. In the mid-20th century, the American Friends Service Committee introduced the idea of sweat equity in the Penn Craft self-help housing project. Families came together to build homes, using labour and sweat as equity. Homeowners could perform D.I.Y improvements and increase the value of their homes significantly. Families felt a greater sense of belonging when their efforts were invested. This idea emphasizes the value of effort and commitment in building homes and communities.

Sweat Equity Shares was introduced in India through Section 79A in the Companies Act 1956 via the Companies (Amendment) Act 1999.

This Article examines the issues surrounding the issuance of sweat equity shares to assist decision-making at the corporate level.

Key considerations

(i) An employee who is a promoter or belongs to the promoter group and a director who either himself or through relatives or body corporate directly or indirectly holds more than 10% of the outstanding equity shares of the company cannot be issued Employee Stock Options (ESOPs). However, a private or public company registered in India may issue sweat equity to its directors or employees.

(ii) A company may issue sweat equity shares of a class of shares already issued, after one year has, at the date of such issue, elapsed since the date on which the company had commenced business. It is arguable if the date of issuance of Certificate of Commencement of Business would be construed as the date on which the company had commenced business.

(iii) In the case of unlisted companies, the issuance of sweat equity shares shall not exceed 15% of the existing paid-up equity share capital in a year or the shares of issue value of INR 5 crore, whichever is higher. At any given time, the issuance of sweat equity shares shall not be more than 25% of the paid-up equity share capital.

For startups, the issue of sweat equity shares shall not exceed 50% of the paid-up capital up to 10 years from the date of incorporation or registration.

A listed company can issue sweat equity shares for up to 15% of its existing paid-up equity share capital in a year. At any given time, the issuance of sweat equity shares shall not be more than 25% of the paid-up equity share capital.

A company listed on Innovators Growth Platform is permitted to issue not more than 15% of the paid-up equity share capital in a financial year subject to an overall limit not exceeding 50% of the paid-up equity share capital of the company, up to 10 years from the date of its incorporation or registration.

(iv) As of June 11, 2015, companies have been allowed to issue “sweat equity shares” to its employees/ directors or employees/ directors of its holding company or joint venture or wholly owned overseas subsidiary/ subsidiaries who are resident outside India, subject to compliance with the terms of regulations issued under the Securities and Exchange Board of India, 1992 or the Companies (Share Capital and Debentures) Rules, 2014 notified by the Central Government under the Companies Act 2013, and sectoral cap applicable to the said company.

In a company where foreign investment is under the approval route, issuance of sweat equity requires prior Government approval.

An individual who is a resident outside India exercising an option issued when he/ she was a resident in India is permitted to hold the shares so acquired on exercising the option on a non-repatriation basis.

(v) Sweat equity is issued at a discount or for consideration other than cash. Where sweat equity is issued for consideration other than cash, it must be against providing know-how or making available rights like intellectual property rights or value additions.

‘Value additions’ refer to 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 like 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.

(vi) Sweat equity shares must be locked in for 3 years from the date of allotment, which means that the shares cannot be transferred until the expiration of the 3-year lock-in period.

There is case law to suggest that the issuing company may, by contract, have a call option concerning such shares for a defined reasonable period.

(vii)  In the case of unlisted companies, the valuation of sweat equity shares to be issued shall be determined by a registered valuer as the fair price. A registered valuer shall conduct the valuation of intellectual property rights or know-how or value additions for which sweat equity shares are to be issued. The registered valuer must also report such valuation to the Board of Directors.

(viii) For a listed company, the valuation of the know-how, intellectual property rights or value addition shall be carried out by a merchant banker in consultation with such experts and valuers as it may deem fit, having regard to the nature of the industry and the nature of the valuation of know-how, intellectual property rights or value addition. Further, the merchant banker must obtain a certificate from an independent chartered accountant certifying that the valuation of the know-how, intellectual property rights or value addition is by the relevant accounting standards.

(ix) The treatment of sweat equity shares in the books of accounts of the issuing company shall be by the manner as applicable and prescribed under the Companies (Share Capital and Debentures) Rules, 2014 and Securities and Exchange Board of India (Share Based Employee Benefits and Sweat Equity) Regulations, 2021.

(x) The rights, limitations, restrictions and provisions applicable to equity shares also apply to the sweat equity shares issued under the Companies Act, 2013. The holders of such sweat equity shares rank pari passu with other equity shareholders.

Challenges

The Companies legislation lays out the parameters for issuance of sweat equity. Arguably, once sweat equity is issued, the holder is like any other shareholder and would be subject to the terms of a contract with the company and the other shareholders.

The above line of discussion appeals to logic, but it may result in a situation that defeats the very purpose of issuing sweat equity. The case discussed below offers a starting point for an enquiry regarding the extent to which additional conditions may be imposed with respect to the sweat equity shares.

In the case of Gateway Distriparks Limited and Ors. v. Ranjiv Kumar Bhasin (2020 (5) MhLj 573), the validity of the call option with the issuing company in respect of the sweat equity shares was addressed.

The employee, Ranjiv Kumar Bhasin (R.K.B.), was the General Manager of the issuing company, Gateway Rail Freight Limited (a subsidiary of Gateway Districtparks Limited). R.K.B., along with another employee, was issued sweat equity shares, and the contractual arrangement was documented in a tripartite agreement among R.K.B., the other employee and the issuing company.

Under the said tripartite agreement, the sweat equity shares were subjected to two lock-in periods. The first lock-in period was 3 years from the date of allotment of the sweat equity shares as required under the Companies Act,2013. The second lock-in period was a staggering lock-in period, whereunder:

(i) The issuing company had the option to call upon the employee, anytime during year 1 following the statutory lock-in period of 3 years, to sell back 40% of the sweat equity shares issued to him.

(ii) The issuing company had the option to call upon the employee, anytime during year 2 following the statutory lock-in period of 3 years, to sell back 20% of the sweat equity shares issued to him.

R.K.B. resigned after the 3-year statutory lock-in period but during year 1 following the statutory lock-in period of 3 years. The issuing company called for the repurchase of 40% of sweat equity shares after the expiration of the 5-year tenure of the tripartite agreement. RKB argued that the issuing company did not have the right to exercise the call option during the tenure of the tripartite agreement. The matter was escalated for arbitration in accordance with the tripartite agreement.

The Arbitrator held as under:

“30. A plain reading of clause 6 (of the tripartite agreement) indicates that the shares issued to the Respondent (read RKB) can be purchased by GDL (read holding company of the issuing company) at a discounted price immediately upon the Respondent leaving the services of GRFL (read issuing company) after the statutory lock-in period but before the completion of the Term. Had the Claimant wished to purchase the said shares, they ought to have been diligent in exercising the option conferred upon them by the contract.

The portion in parenthesis is ours.

Aggrieved by the decision, the issuing company challenged the arbitral award. The Hon’ble Bombay High Court held as under:

“… there is the all-important expression ‘GDL will have the option’. Mr. Kelkar’s argument before me (and before Ms. Mistry in arbitration) totally overlooks this. GDL did not have to make this call. It could choose to do so. It seems to me self-evident that the option had to be exercised at some known point in time. The time for exercising that option could not be indefinitely open-ended or continue so long as Bhasin held the sweat equity shares. To interpret it that way would be both unfair and unreasonable. What Ms. Mistry did, and in my view correctly, was to conclude that ‘during such period’ would qualify ‘shall have the option’, i.e. the time when that option made to be exercised, failing which it was foresworn. This is important, for it speaks to ‘option’. When might one say the option was foregone, given up, and unavailable any longer? On Mr. Kelkar’s construct, the answer is never; this would be an option available in perpetuity. That is entirely unreasonable. It put Bhasin’s sweat equity under a perennial cloud for all time to come, with no time-restriction at all applicable to GDL within which it had to exercise its ‘option‘.

Therefore, putting these two together, we get the following result: accepting the Petitioners’ arguments would introduce an unacceptable redundancy in the contract by making ‘during such period’ synonymous with ‘under clause 4’; and it would simultaneously leave open, essentially in perpetuity, the time when GDL could exercise its ‘option’, thus effectively putting a stranglehold forever on Bhasin’s sweat equity shares. That would be a resultant absurdity in interpretation of the contract, and Ms. Mistry therefore correctly abjured it. On the other hand, by positioning ‘during such period’ against ‘shall have the option’ returned an entirely viable result: requiring GDL to act with promptitude in exercising its option. If it did not do so during such period, it could not do so thereafter. That is hardly an unreasonable or unfair view. To the contrary, it seems to me to both reasonable and fair, and not just a plausible or possible view, but the only one that could have been taken. I am in complete agreement with the interpretation placed by Ms. Mistry. Her decision is admirably compact and precise.”

While the court did not have to examine if, in the first place, a restriction of the present nature was valid, it is clear that the Court did consider the fact that the sweat equity issued to the employee must serve its purpose – it would not be fair or reasonable to state that such shares could be subject to call option in perpetuity.

Viewpoint

Undoubtedly, ‘sweat equity’ as a concept is appealing because it recognises human capital – but it may pose challenges that must be carefully evaluated, assessed and addressed.

Founding a company often encompasses a diverse range of contributions. Some individuals supply funds, others may choose to put in time and effort in exchange for the potential of sharing the company’s success in the future. In pursuing this potential share in the success through sweat equity, an employee may even sacrifice their monetary compensation, wholly or partially. One needs to remember that ‘ownership’ and ‘compensation’ are different concepts and intertwining the two in the context of sweat equity can sometimes lead to unforeseen circumstances.

The decision whether to issue sweat equity may be made after considering, among other things, HR, tax, and legal perspectives.

The trouble with sweat equity arises concerning the valuation of know-how or intellectual property rights or value additions against which sweat equity is to be issued, especially when contributions are by more than one person and at multiple levels. The trouble is compounded because, more likely than not, the valuation of the same intellectual property rights or know-how will vary with time, depending on related developments.

Sweat equity may be perceived as a ‘loyalty’ bonus. Ironically, the tendency may be to move to greener pastures once the loyalty is rewarded.

If a company decides to issue sweat equity, it would be ideal to draw up a sweat equity scheme and have a well-crafted sweat equity agreement to address eventualities like cessation of employment.

Disclaimer

The Bar Council of India Rules do not permit law firms to solicit work or advertise. By clicking the ‘I Agree’ button the Reader accepts that it seeks information on its own accord. Alaya Legal shall in no way be responsible for any technical inaccuracies in the website, or for any actions taken or not taken for reasons attributable to the information contained in this website or accessed through this website. Readers are advised to seek counsel from a qualified professional while dealing with specific issues.By continuing to use this site you consent to use of cookies on your device as mentioned in this cookie policy.

Alaya Legal shall in no way be responsible for any technical inaccuracies in the website, or for any actions taken or not taken for reasons attributable to the information contained in this website or accessed through this website. Readers are advised to seek counsel from a qualified professional while dealing with specific issues.The views appearing under various heads, including ‘Trending’, are those of the author. The author may be reached at by writing to Alaya Legal at contact@alayalegal.com Nothing herein is or may be construed as legal advice.