Analysing the Change in Law Regarding Issuance of Sweat Equity Shares

[Vartika Tiwari is a 3rdYear student of National Law Institute University, Bhopal and is on the Editorial Board of NLIU Law Review]

On 16 January 2016, the Government launched the “Startup India”campaign and ever since it has been making constant efforts to promote startups and make the country business friendly. There is no denying the fact that India has come a long way since then. In fact, it is now ranked amongst the top 100 countries in the World Bank’s ‘Ease of Doing Business’ index. However, the Government aims to do better in the rankings. Consequently, amongst other things, there has been a recent amendment in the Companies (Shares and Debentures) Rules, 2014 with respect to grant of sweat equity shares to employees. According to the new rule, sweat equity may even be granted to an employee who has just joined the company.

What are Sweat Equity Shares?

The Companies Act, 2013 (the “Act”) in section 2(88) defines sweat equity shares as “such equity shares as are issued by a companyto its directors or employees at a discount or for consideration, other than cash, forproviding their know-how or making available rights in the nature of intellectual propertyrights or value additions.” Sweat equity shares are governed by section 54 of the Act and Rule 8 of The Companies (Shares and Debentures) Rules, 2014 (the “Rules”).

The 2018 Amendment  

Rule 8 of the Rules lays down the various conditions that an unlisted company needs to comply with in order to issue sweat equity shares. Among other things, a basic condition in Rule 8(1)(a) is that for an “employee” to be eligible for a sweat equity share, he should have been a permanent employee of the company (working in India or outside India) for at least one year. 

On 7 May 2018, the Rules were amended (“Amended Rules”). The Amended Rules seek to change the definition of an “employee” to omit the minimum one-year employment requirement, meaning thereby that a company can issue sweat equity shares to even an employee who has recently joined the company. The implications of this are twofold: for the company, it means that the company will be able to retain talent by providing them with incentives in the form of sweat equity shares; and for the employee, it means that he will be duly awarded for his “value additions” as soon as he joins a company.

How will it Change the Game?

Interestingly enough, an amendment was brought about to the Act by way of the Companies (Amendment) Act, 2017 to remove a restriction on companies that prevented them from issuing sweat equity shares within one year of commencement of business. This enables start-ups to issue sweat equity shares immediately after incorporation – something that was not allowed earlier. Thus, it is clear that the aforementioned amendments have been brought about with the intention of furthering the Government’s ‘Startup India’ initiative, and specifically to help startups to retain talent.

While it is safe to say that the Amended Rules will most likely help companies tackle attrition and make quality employees available to startups, it cannot be denied that it also poses a major risk for the startups by reducing the period within which employees are granted sweat equity shares.  Further, it might dilute the equity of startups, which is not always in interest of the founding members, who might want to keep a tight control over the shareholding.

In order to overcome these concerns, it may be reasonable for the Ministry of Corporate Affairs to fix an initial cap on the maximum amount of sweat equity that can be issued to an employee or it can be phased out over the year, based on the employee’s performance. Additionally, a rule of caution should be applied in case of issue of sweat equity to employees with less than one-year work experience. Accordingly, for startups, sweat equity should be an exception and not a rule.

  • Vartika Tiwari

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1 comment

  • Great insight. However, I would disagree on the recommendation provided by the author to fix an initial cap on the maximum amount of sweat equity shares issued to employees on the following grounds: (i) For each sector, there will be different performance parameters for employees. (for example, in PR / marketing and consulting companies, the performance of the employee will be based on the number of clients and the employee’s ability to provide good service standards whereas in a sector specific company such as shipping, the performance criteria would be entirely different). (ii) Each company/startup would have different company goals that would in turn incentivise the employees hence a blanket cap of maximum number of sweat equity shares would in turn dissuade good talent in some cases, if not found to be as per the performance of the new employee(s).

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