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Dec 7, 2016

Sweat Equity Valuation – Opportunities and Challenges

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he new age companies are keen to keep the best employees who bring in their know-how, and technical expertise that adds to the business value of a company. In order to keep them motivated and involved, companies are going an extra mile to reward them by giving them ESOPs / Sweat Equity.

It’s a win-win situation and also helps company to limit its fixed cost. The employees feel like entrepreneurs and gets rewarded multiple times once the company scales up and its valuation increases.

This mechanism of issuing ESOP / Sweat Equity Shares involve sharing the ownership of the company with the employees at a discounted value to the Fair Value of Shares. It may be noted that only a company which has commenced its business for minimum one year can issue sweat equity shares.

As per the provisions of the Company Law and Securities and Exchange Board of India (SEBI) Guidelines, ESOP’s cannot be issued to promoters, independent directors and any director holding 10 percent equity (except the recently exempted Start-up’s as defined under the Act who have been permitted to issue ESOP to promoters and directors holding 10 percent shares up to 5 years from the date of incorporation)

Is there a way then to reward the promoters and such directors already holding 10 percent equity?

There is a silver lining – “Sweat Equity shares” This article is discussing about the same and is highlighting its opportunities and challenges.

Sweat equity shares are such shares, which are 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 for which the consideration is ‘not’ paid or included in:

    a) the normal remuneration payable under the contract of employment, in the case of an employee; and/or

    b) monetary consideration payable under any other contract, in the case of non-employee.

There are certain advantages of issuing Sweat Equity Shares over ESOP’s-

Sweat Equity shares can be given even below the face value of shares. This is the only exception provided in the Companies Act, 2013 which otherwise prohibits issue of shares below the Face Value.

From an employer’s view point, offering sweat equity not only serves as an effective incentive model but at the same time it ensures that its key employees don’t leave the company. This is so because shares allotted under sweat equity gets locked-in for a period of three years from allotment.

Both ESOP’s and Sweat Equity are however subject to levy of tax as perquisites in the hands of the employees under the provisions of the Income Tax Act, 1961. In case of a listed company, the fair market value shall be average of opening and closing market prices on the date of exercise of option. And in case of an unlisted company, valuation of shares will be done by a SEBI Registered (Cat-I) Merchant Banker. The tax rates would depend on the salary slab of the employee.

Besides valuation for determination of share price for accounting purposes, another valuation is required to assess the value of technical know how or IPR or value additions. Such valuation has to be done by a merchant banker in case of listed companies and by a merchant banker or CA with 10 year of work experience in case of unlisted companies.

Limit to issue Sweat Equity

A company is allowed to issue sweat equity shares up to 15 percent of the existing paid up equity share capital in a year or shares of the issue value of Rs 5 crores, whichever is higher. In addition, the overall issuance of sweat equity shares in the company shall not exceed 25 percent of the paid up equity capital of the company at any time (other than in case of start up’s as defined under the Act which are permitted to issue sweat equity shares not exceeding 50 percent of their paid up capital up to 5 years from the date of its incorporation)

Valuation Approaches for Sweat Equity Shares

It is pertinent to mention that the accurate quantification of the intangible gains made by the company consequent to the contribution of a person is difficult to be ascertained in absolute numerical terms and involves careful consideration and review of various parameters that directly and / or indirectly contribute to business expansion with consequent accretion in value. These include:

  • The general economic outlook as well as the current and expected conditions in the business environment and the industry’s relationship with the economy.
  • The competitive environment prevailing within the industry.
  • The relative competitive advantages of the business in terms of its service capability.
  • Management capabilities and the quality of the clients of the entity.
  • The management of the Company.
  • The historical financial and operational performance of the business, etc.

There are three approaches to valuation in general (Cost, Market and Income approach). For something intellectual in nature, cost approach cannot factor in the real value as it will just reflect the cost incurred till date and it’s quite difficult to apply market approach to value contribution of a Person though it can be used as rule of thumb as a sanity check. The only method left then is Income approach and Discounted Cash Flow method can be used to arrive at the value of Intangible. In practice, two DCF are undertaken – one values the company as such and another values the company without that person. The differential (after certain adjustments including the amount paid as Salary and attributing a certain portion to his team) could be attributed to the value additions of that person.

Such non-cash consideration shall be treated either as a Depreciation Asset else expensed in the books as form of compensation. Interestingly in case the sweat equity takes form of an Asset, it is not treated as part of Managerial Remuneration.

To conclude, issue of Sweat Equity shares need proper planning and understanding of legal aspects besides the ability to Value IPR and technical know-how of a person. No doubt it’s a tool to incentivize employees and also Management (both Executive and Non-Executive Directors) and Promoters of a Company.