What is Sweat Equity?

Last Updated on September 27, 2023 by BFSLTeam BFSLTeam

Money is not the only thing that makes small businesses grow into conglomerates and become industry leaders. The contributions and dedications offered by the employees are the key factors that shape the future of any company. As a reward to these contributions, companies issue sweat equity shares to those employees who are the pivots of its working and growth. It helps measure these non-monetary contributions and makes it possible for the company to reward key personnel with sweat equity shares. Read on to know the meaning, shares, and why they are important.

What is Sweat Equity?

The meaning of sweat equity is simple. It is essentially the non-monetary contribution made by any individual to a company. This individual could be a founder, director or any other key management personnel or professional in the company. Their non-monetary contribution to the company may be in the form of physical labor, mental efforts or intellectual property. It is distinct from equity capital, which is a monetary contribution to fund the growth of the company. 

Let’s take a closer look at an example to understand how sweat equity works. Say a company’s founder values her efforts in building the company at Rs. 50 lakhs. When the company approaches an angel investor or a VC for funding, let’s say the investor is interested in a 10% stake in the company in return for an investment of Rs. 10 lakhs. This effectively values the company at Rs. 100 lakhs. 

The founder retains a 90% stake in the company, which amounts to Rs. 90 lakhs. This sum includes her contribution worth Rs. 50 lakhs and sweat equity worth Rs. 90 lakhs. 

While this is a fairly straightforward example, in the real world, companies issue sweat equity shares to reward key personnel in the business for their sweat equity.

Also Read: Difference Between Equity and Preference Shares

What are Sweat Equity Shares?

In simple terms, these are shares issued to certain employees who have contributed to the company in terms of sweat equity. A more technical definition can be found in section 2(88) of the Companies Act, 2013. As per this section, ‘sweat equity shares are those securities that are offered to employees and/or directors of a company for any of the following reasons:

• Remarkable contribution and efforts in completing a project 
• Technical expertise in any given field that is relevant to the company’s business
• Value addition to the company in the form of some extraordinary contribution
• Gaining intellectual property rights 

Are All Employees Eligible for Sweat Equity Shares? 

No, not all the employees in a company will be eligible for receiving sweat equity shares. This category of shares is restricted to certain classes of employees as per Rule 8 of the Companies (Share Capital and Debentures) Rules, 2014. The following types of employees will be eligible:

• Permanent employees
• Directions

The employees in the above categories will be eligible for sweat equity shares for the following types of contributions made to the company: 

• Intellectual Property Rights (IPRs)
• Technical know-how
• Any other kind of non-monetary value addition to the company 

Pricing and Valuation

Shareholders often wonder how sweat equity shares are priced and valued. There is no specific method that is universally adopted for this purpose. Here are some important points about the pricing and valuation of such exclusive shares. 

• A Registered Valuer is Responsible For This

Generally, companies hire a registered valuer to determine the fair price of sweat equity shares. The valuer will adopt the method of valuation they see fit, and offer an explanation for the same.

• Valuation of Intellectual Property Rights and Technical Know-How

IPRs, technical know-how and other value additions are all intangible assets. These assets will have to be valued differently than tangible assets. As per the norm, the registered valuer hired by the company will carry out the valuation in the manner they think fit and submit a report to the company’s Board of Directions about the methods used. 

• Communication to Shareholders

The valuation report prepared by the valuer will also be submitted to the shareholders along with the notice for the Extraordinary General Meeting (EGM). 

• Issue of Sweat Equity Shares for Non-Cash Consideration

Sweat equity shares may also be issued for non-cash consideration. This is done on the basis of the value of the sweat equity as determined by the registered valuer. In such cases, here is how the company should treat the non-cash consideration in its books of accounts:

• If the non-cash consideration is offered in the form of assets that can be depreciated or amortized, it will be reflected in the company’s balance sheet as per the accounting standards applicable 
• If the above condition is not true, the consideration is considered an expense

3 Reasons Companies Issue Sweat Equity Shares

A company may issue sweat equity shares for a number of reasons. Some of the top driving factors behind this kind of issue are outlined below. 

• Attracting and Retaining Top Talent

One of the main reasons for issuing sweat equity shares is to attract and retain top talent. If the sweat equity shares have a lock-in period, they cannot be transferred during this window of time. So, for this duration, the top talent that the company has employed will remain within its employment, thus giving it a competitive advantage over its peers. 

• Preference over ESOPs

ESOPs give employees the right to buy shares after a specified vesting period. However, sweat equity shares are directly allotted to eligible employees and directors at a specific price. This makes the process much more certain and removes an ambiguity that may be associated with future prices and market volatility. 

• Objective Rewards for Sweat Equity

Since the valuation of sweat equity and the shares issued for this purpose are done by registered valuers, employees and companies can benefit from an objective and transparent process. This also gives the company an opportunity to reward deserving employees at the fair value of their sweat equity. 

How Many Sweat Equity Shares Can a Company Offer?

The number or value of sweat equity shares that a company can issue is typically restricted as follows:

• Should be up to 15% of the paid-up capital of the company during the year of issue
• Should be limited to the value of Rs. 5 crores
• Should not exceed 25% of the paid-up capital of the company  (startups can issue upto 50% of their paid-up capital)

Also Read: Authorized Share Capital: Definition, and Types

Conclusion

Sweat equity shares are rewards for extraordinary employees who have made exceptional contributions to the growth of a company. These shares are exclusive. While it is an incentive to the talent, it is also aimed at retaining the talent. 

That said, These shares ultimately help a company reward deserving permanent employees and directors who made significant non-monetary contributions to the company.