ESOP & Sweat Equity: Most Prevalent & Contemporary Modes for Rewarding Employees

The management of the newly incorporated Companies or the Companies opting for diversification generally believes in the practice of inducing the best executives and employees who bring in their know-how, skill and technical expertise that ultimately results in augmenting the business value of the enterprise.

Ms. Anjali Aggarwal
Vice President
+919971673336
anjali@indiacp.com

Nowadays, Organisations are using value enhancing mechanisms to inculcate a feeling among key professionals to undertake tasks independently as Entrepreneurs that would not only result in their own professional development but would also leads to enhancement in their personal wealth. Such value enhancing mechanisms involves issuance of shares for their hard work and contribution in the form of Intellectual Property Rights (IPR), know-how, skill and technical expertise. The shares issued to such employees (either at a discounted price or against the know-how contributed) are, in legal parlance be termed as "Sweat Equity".

However, this does not mean that Sweat is only meant for start-ups. The companies, which are already well-established, may also offer Sweat Equity to its employees for their providing know-how, to the company.

On the other hand, as the company grows, the management would make all requisite efforts to retain the best talent of their Organisation who have been the stepping stones for the growth of the business by offering them additional incentives as a reward for their hard work and association. Such employees are offered ESOP at a price which is less than the market value of the share. ESOP is a good retention tool as well as a tool to recognize loyalty and performance of employees.

Today many business entities (whether existing market player or a Startup) both at India and abroad, are utilizing this scheme as an essential tool in order to Recruit, Retain and Reward, their real jewels.

Statues Governing Sweat and ESOP 

1. Companies Act, 2013: 

• Section 2(88) of the Companies Act, 2013 defines “sweat equity shares” as the shares issued by a company to its directors or employees at a discount or for consideration, other than cash, for providing their know-how or making available rights in the nature of intellectual property rights or value additions, by whatever name called. 
• Section 54 of the Companies Act, 2013 provides that a company may issue sweat equity shares of a class of shares already issued provided that the issue is authorised by special resolution specifying the details of the issue. It must be noted that sweat issue shall not be made unless one year has elapsed since the company had commenced business. 
• Section 62(1)(b) of Companies Act, 2013 provides that a company having share capital can increase its subscribed capital by the issue of further shares to employees under a scheme of employees stock option, provided that the same is authorised by special resolutions.

2. SEBI Regulations 

• SEBI (Issue of Sweat Equity) Regulations, 2002 provide the framework which shall be taken into consideration while issuing sweat equity shares. 
• SEBI (ESOS and ESPS) Guidelines, 1999 provides the framework which governs the issue of ESOPs by listed public companies. 

3. Income Tax Act, 1961

• Section 17(2)(vi) of the Act provides that the value of any specified security ( which thereby covers ESOP) or sweat equity shares allotted or transferred, by the employer to the employee shall be taxed as perquisite in his hands. 

4. FEMA Act, 1999

• Regulation 8. D. of FEMA (Transfer of shares/convertible debentures from Resident to Person Resident Outside India), Regulations provides that, the face value of the shares to be allotted under the ESOP scheme to the non-resident employees should not exceed 5 per cent of the paid-up capital of the issuing company.
• FDI Policy on Issue of Shares for consideration, other than cash,provides that any type of transaction involving an issue of shares to foreign investors for consideration other than cash requires approval of the Government of India through the Foreign Investment Promotion Board (FIPB).

Comparison between Stock Options and Sweat Equity

SWEAT EQUITY	ESOP
Sweat Equity shares are issued to employees or directors for providing know-how / IPRs.	ESOP is used as a retention tool. These are issued to employees as an incentive / reward.
Issue of Sweat Equity is governed by Section 54 of Companies Act, 2013, read with Rule 8 of Companies (Share Capital and Debenture) Rules, 2014.	Issue of ESOP is governed by Section 62(1)(b) of Companies Act, 2013, read with Rule 12 of Companies (Share Capital and Debenture) Rules, 2014.`
Sweat Equity Shares can be issued to promoters.	ESOPs cannot be issued to promoters.
These Shares have a compulsory lock-in period of 3 years from the date of allotment.	Lock-in period is not specified for ESOP.
Sweat issue is a one-time plan.	ESOP is a long-term plan, which spreads over a number of years as per the scheme of the company.
Sweat is a sharing in the capital of the company as the employees / directors are offered equity shares.	In case of ESOPs, it is not necessary that sharing should be in the share capital of the company. There are various restructuring modes under ESOP, such as SARs, Phantom Stocks, in which employee does not get shares of the company, but cash reward relating to appreciation in the value of the company.
The company shall not issue sweat equity shares for more than 15% of the existing paid-up equity share capital in a year or shares of the issue value of 5 crore, whichever is higher.	There is no such restriction in case of ESOPs.
The amount of sweat equity shares is treated as part of managerial remuneration, depending upon case to case.	ESOPs also form part of managerial remuneration.
Sweat Equity Shares are taxable as perquisite in the hands of employees in accordance with Section 17(2) of Income Tax Act, 1961.	ESOPs are also taxable as perquisite in the hands of employees in accordance with Section 17(2) of Income Tax Act, 1961.

ESOP and Sweat Equity are like carrots that can be used diligently for rewarding Employees for their performance as well as for retaining best talent in the Organisation. Considering the above comparison between the two, it can be concluded that, both Sweat and ESOP have their own pros and cons. If implemented intelligently, these tools can result in creating a win-win situation for both, the Company as well as Employees.