Evolution Sweat Equity Shares: Pros and Cons

A. Sweat Equity Shares - Evolution

Sweat equity refers to work one does to build up value without a salary. This ownership interest, or increase in value, is created as a direct result of hard work by the owner. For example, homeowners who renovate or repair their house themselves are investing in sweat equity that increases the value of their home. Or it could be a non-monetary benefit that a company's stakeholders give in labour and time, rather than a monetary contribution that benefit the company. In some cases, sweat equity may be rewarded in the form of sweat equity shares. These are shares given out by a company in exchange for labour and time rather than a monetary amount.

Sweat equity in real estate

Sweat equity has an application in business real estate, for example, where the owners put in effort and toil to build the business, in real estate where owners can perform D.I.Y. improvements and increase the value of the real estate, and in other areas such as an auto owner putting in their own effort and toil to increase the value of the vehicle.

The term sweat equity explains the fact that value added to someone's own house by unpaid work results in measurable market rate value increase in house price. The more labor applied to the home, and the greater the resultant increase in value, the more sweat equity has been used. The concept of sweat equity was first employed in the United States by the American Friends Service Committee in the Penn Craft self-help housing project beginning in 1937. The AFSC began using the term in the 1950s when helping migrant farmers in California to build their own homes. It is perhaps most popularly associated today with a successful model used by Habitat for Humanity, in which families who would otherwise be unable to purchase a home contribute sweat equity hours to the construction of their own home or the homes of other Habitat for Humanity partner families, or by volunteering to assist the organization in other ways. Once living in their new home, the family then make interest-free mortgage payments into a revolving fund which then provides capital to build homes for other families.

In the Indian context Sweat Equity Shares under Companies Act, 2013 means that such equity shares as are issued by a company to its directors or employees at a discount or for consideration, other than cash for providing them know how or making available rights in the nature of intellectual property rights or values addition, by whatever name called.

B. Legal framework for issue of sweat equity shares

Section 2(88) of Companies Act, 2013 defines sweat equity share as the equity 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 in the nature of Intellectual property or value addition to the company.

Rule 8 of the Companies (Share Capital and Debenture) Rules, 2014 define employee as

1. A permanent employee of the company who has been working in or outside India for a period of at least one year;
2. A director of the company, it can be a whole time director or any other director;
3. An employee or director working in the holding company or subsidiary of a company.

Section 54 of the Companies Act, 2013 provides for the issue of sweat equity shares subject to fulfillment of following conditions

1. Sweat Equity issues should be authorized by a special resolution.
2. The resolution should contain information about the number of shares, current market value of the shares, consideration and to the class of employees or directors to whom the shares are being issued.
3. The special resolution has to act within 12 months of passing otherwise it will be rendered invalid and a fresh resolution has to be passed again.
4. Sweat Equity shares shall be issued in accordance with the SEBI regulations.
5. The rights, limitations, restrictions and provisions which are applicable to equity shares shall also be applicable to sweat equity shares. 
6. The sweat equity shares which are issued to directors and employees shall be locked in and is non-transferable for a period of three years. The non-transferability of the shares shall be mentioned in bold on the share certificate.

Securities and Exchange Board of India has issued separate regulations for governance of sweat equity in 2021.

Pros of sweat equity

• Its A Way to Attract Top Talent: If you're a startup company with a limited budget, offering sweat equity can be a great way to attract top talent. People are often more motivated to work hard when they have a stake in the company's success.
• It Can Save You Money: Offering sweat equity instead of monetary compensation can save you a lot of money, especially in the early stages of a company's development. This can give you more financial flexibility to invest in other areas of your business.
• It Can Create A Sense Of Loyalty: People who have a stake in the company's success are more likely to be loyal to the company and stick around for the long haul. This can be beneficial for businesses that want to build a strong team of employees.
• Increased productivity: employees are often motivated to be more productive if they have a stake in the business
• Aligned incentives: Founders and employees are nicely aligned towards the long-term success of the company
• It can help recruit and retain top talent.

Cons of Sweat Equity

• ​​​​​​​​​​​​​​It Can Create Resentment: If employees feel like they are working harder than others and not being fairly compensated, it can lead to resentment and turnover. Its important to make sure everyone understands the terms of the sweat equity agreement and feels like its fair.
• It Can Lead To Legal Problems: If not handled correctly, offering sweat equity can lead to legal problems. For example, if you offer someone sweat equity and then they leave the company, they may be entitled to a portion of the company's profits. Make sure you consult with an attorney before offering sweat equity to avoid any legal issues down the road.
• It Can Be Difficult To Value: One of the challenges with sweat equity is that it can be difficult to put a monetary value on it. This can make it difficult to keep track of who owns what percentage of the company. You may want to consider hiring a valuation expert to help you determine the value of sweat equity.
• Dilution of ownership: Issuing sweat equity shares dilutes the ownership of existing shareholders, potentially reducing their control over the company
• Performance risk: Sweat equity shares are subject to the risk that the company will not perform as planned, resulting in a decrease in share value or possibly a complete loss of value.
• Liquidity concerns: Employees and directors who receive sweat equity shares may not be able to readily sell them, as they may be subject to lock-up periods or other restrictions. Despite these potential drawbacks, sweat equity shares remain an important tool for companies to attract, retain, and motivate talent. They can be especially beneficial for startups and small businesses that need to conserve cash while rewarding the hard work and dedication of their employees and directors