Sweat Equity Shares under the Companies Act: Meaning, Limits and Procedure

Many startups and small companies depend on a director or a key employee who works for less than market pay, or who brings in technology or know-how that the company cannot pay for in cash. Sweat equity shares let the company reward that contribution with shares instead of money.

This article explains what sweat equity shares are, who can receive them, the limits, and the procedure under Section 54 of the Companies Act, 2013 and Rule 8 of the Companies (Share Capital and Debentures) Rules, 2014.

What are sweat equity shares?

Sweat equity shares are equity shares issued by a company to its directors or employees at a discount, or for consideration other than cash, for:

• providing know-how, or
• making available rights in the nature of intellectual property rights (such as software, designs or technical processes), or
• value additions to the company

They are equity shares of the same class as the existing equity shares, and carry the same rights, unless the terms say otherwise.

Who can receive sweat equity shares?

• A permanent employee of the company, working in India or outside India
• A director of the company, whether whole-time or not
• An employee or director of a subsidiary or holding company

Consultants, advisors and outside service providers who are not employees or directors cannot be issued sweat equity shares. For them, other arrangements such as a fee, a share issue for cash, or an agreement to appoint them as a director may be considered.

Sweat equity, ESOP and share issue for cash

Point	Sweat equity	ESOP	Share issue for cash
What the person gives	Know-how, IP or value addition	Continued employment	Money
When shares are received	At allotment	After vesting and exercise	At allotment
Lock-in	3 years from allotment	As per the scheme	None by law (subject to agreements)
Valuation report	Required for shares and for the IP or know-how	Required for tax purposes	Required where applicable
Approval	Special resolution	Special resolution	Board, and shareholders where needed

ESOPs are discussed in understanding ESOP valuation for startups.

Limits on issue

• In a year, sweat equity shares cannot exceed 15% of the existing paid-up equity share capital, or shares of an issue value of ₹5 crore, whichever is higher
• At any time, total sweat equity shares cannot exceed 25% of the paid-up equity capital
• A startup recognised by DPIIT can issue sweat equity shares up to 50% of its paid-up capital, up to 10 years from its date of incorporation

Conditions

• The issue must be authorised by a special resolution of the shareholders
• The resolution must state the number of shares, the current market price or fair value, the consideration, and the class of directors or employees to whom the shares are to be issued
• The special resolution is valid for allotment within 12 months of passing
• The shares are locked in for 3 years from the date of allotment, and the share certificate is stamped to show the lock-in
• The shares are valued at fair value by a registered valuer
• Where the shares are issued for IP or know-how, that IP or know-how is also valued by a registered valuer, and the valuer’s report is placed before the board and the shareholders

Step-by-step procedure

1. Check the Articles of Association: make sure the AOA does not restrict the issue of sweat equity shares; amend the AOA first if needed
2. Get the valuation: obtain the registered valuer’s report on the fair value of the shares and, where relevant, the value of the IP or know-how
3. Board meeting: approve the proposal, the valuation reports and the notice of general meeting with the explanatory statement
4. General meeting: pass the special resolution
5. File MGT-14: with the ROC within 30 days of passing the special resolution
6. Allot the shares: by board resolution, within 12 months of the special resolution
7. File PAS-3: return of allotment within 30 days of allotment
8. Issue share certificates: stamped with the lock-in, and pay stamp duty on the issue of shares
9. Update registers: the register of members and the register of sweat equity shares in Form SH-3
10. Disclose in the Board’s report: details of sweat equity issued during the year

Accounting and tax

• Where sweat equity is issued for services, the value is generally treated as an expense in the company’s books; where it is issued for an asset such as IP, it may be shown as an asset
• For a director or employee, the fair market value of the shares, less any amount paid, is taxed as a perquisite under Section 17(2)(vi) of the Income-tax Act in the year of allotment
• When the shares are sold later, capital gains are calculated using the fair market value taken for the perquisite as the cost

Practical points

• Document the contribution clearly in an agreement: what the director or employee is providing, and what IP is being transferred
• Have a written assignment of the IP to the company, so the company owns what it is paying for. See how startups can protect intellectual property
• Check the effect on the shareholding pattern and control, and on any shareholders’ agreement
• Check the tax impact on the recipient before allotment, since tax is payable even though no cash is received
• For co-founders, consider whether sweat equity, an ordinary share issue at face value, or reverse vesting suits the situation better. See startup structuring and co-founder equity

Points for companies in Kerala

• Many small IT and technology companies in Kerala begin with a technical co-founder who writes the code; sweat equity is one way to recognise that work once the company is formed
• Family companies sometimes use sweat equity for a family member who manages the business without salary; the same conditions and valuation apply
• Stamp duty is payable on the issue of shares; check the current rate and payment method before allotment

Frequently asked questions

Can a private limited company issue sweat equity shares?

Yes. Section 54 applies to all companies, including private companies, subject to the conditions and limits above.

Can sweat equity be given to a consultant?

No. Only permanent employees and directors of the company, or of its holding or subsidiary company, can receive sweat equity shares.

Can the shares be sold during the lock-in?

No. Sweat equity shares are locked in for 3 years from allotment and cannot be transferred during that period.

Is a valuation report compulsory?

Yes. The shares must be valued by a registered valuer, and where the consideration is IP or know-how, that must also be valued.

Does the recipient pay tax even if no cash is received?

Yes. The value of the shares, less any amount paid, is taxed as a perquisite in the year of allotment.

ചുരുക്കം (Summary in Malayalam)

കമ്പനിക്ക് സാങ്കേതിക അറിവ്, ബൗദ്ധിക സ്വത്ത് (IP), അല്ലെങ്കിൽ മറ്റ് സേവനങ്ങൾ നൽകുന്ന ഡയറക്ടർമാർക്കും സ്ഥിരം ജീവനക്കാർക്കും പണത്തിന് പകരം ഓഹരി നൽകുന്നതാണ് sweat equity shares. Section 54 പ്രകാരം special resolution, registered valuer-ന്റെ valuation, 3 വർഷത്തെ lock-in എന്നിവ നിർബന്ധമാണ്. ഒരു വർഷം paid-up capital-ന്റെ 15% അല്ലെങ്കിൽ ₹5 കോടി, ആകെ 25% വരെയാണ് പരിധി; DPIIT അംഗീകൃത സ്റ്റാർട്ടപ്പുകൾക്ക് 10 വർഷം വരെ 50%. Consultants-ന് sweat equity നൽകാൻ കഴിയില്ല. ലഭിക്കുന്നയാൾക്ക് perquisite ആയി നികുതി ബാധകമാണ്.

This article gives a general overview of the law and procedure under the Companies Act, 2013, the rules and related laws. Forms, fees, limits and procedures are revised from time to time; for accurate and current requirements, refer to the Act, the rules as amended and the official portals. The article is not advice on any particular case.