ESOP vs Sweat Equity – Everything You Need To Know
India has become one of the global startup hubs. As of 2022, estimates show that there are more than 80,000+ startups registered and recognized by DPIIT. As the number of startups grow, so do the number of jobs generated by these startups. Research shows that there are more than 7.68 lakhs jobs created by startups over the last six years.
Most of these startups offer equity-based compensation as a part of their salary packages. Reasearch by Saison Capital shows that the equity-linked compensation accounts for around 40-60% of the leadership team’s salary.
In this article, we look at two of the most common equity-linked payment structures – ESOP vs Sweat Equity.
Common Equity-Linked Compensation: ESOP vs Sweat Equity
ESOPs: Section 2(37) of the Companies Act, 2013 defines Employee Stock Option Plans. According to the said section, “the option given to the directors, officers, or employees of a company or of its holding company or subsidiary company or companies, if any, which gives such directors, officers or employees, the benefit or right to purchase, or to subscribe for, the shares of the company at a future date at a predetermined price” is called an ESOP.
In simple terms, the Company offers ESOPs, which carry a right to purchase shares at specified price on a future date. When an employee gets an ESOP grant, he/she only gets a “right” to purchase shares in the future. They are not shareholders. They become shareholders when the Company issues equity shares, (i.e. when they exercise the options).
Sweat Equity: According to Section 2(88) of the Companies Act, 2013, “shares issued by a company to its directors or employees for non-cash consideration or at a discount for making rights available in the nature of intellectual property rights or providing know-hows or providing any intellectual value additions to the company in any form”.
In this case the Company issues sweat equity shares. Unlike options, the Company issues actual shares to the employee. Rule 8 of Companies (Share Capital and Debentures) Rules, 2014 regulates the procedure of issue of sweat equity shares.
Key Differences – ESOP vs Sweat Equity
|Nature||ESOPs are issued to employees as a long-term retention strategy, where employees are given the “right” to purchase the shares of the company, at an agreed price, at a future date||Sweat Equity is equity shares issued by a Company usually to compensate for the efforts put in by the employee. It is also commonly used to purchase the nature of intellectual property rights or value additions to the Company.|
|Who Can Get||Any employee, except those who are a part of the promoter or promoter group.||Any employee including promoters|
|When Can They Be Issued||There are no restrictions for ESOP. They can be issued at any point of time of during the lifetime of the Company.||Sweat Equity shares can be issued only if the Company has been in existence for at least a year.|
|Restrictions on Issue||No restrictions on the creation of the option pool.||Sweat Equity shares cannot be issued for more than 15% of the paid-up value of the Company in a year, or Rs.5 crores, whichever is higher. The overall cap is 25% of the paid-up share capital of the company. For DPIIT registered startups, the cap is 50% of the paid-up share capital of the Company.|
|Pricing Guidelines||There are no pricing guidelines defined in The Companies (Share Capital and Debentures) Rules, 2014||Pricing guidelines are to be determined by a registered valuer.|
|Stages||An ESOP usually goes through the following stages: Grant -> Vesting -> Exercise -> Allotment||There are no such stages. Sweat equity can be issued directly, subject to the minimum criteria of one year (discussed above).|
|Consideration||The consideration for ESOPs, at the time of exercise, must be paid in cash.||Sweat Equity can be issued for cash at a discount or other than cash consideration.|
|Lock-in Period||There is no lock-in period. Employees can sell their shares upon allotment.||There is a mandatory 3-year lock-in period for sale/exit of sweat equity shares.|
What is the Procedure to Issue ESOPs
Step 1: Create the Option Pool
The first step is to create the option pool (i.e. the number of shares that you set aside for issue to employees).
Step 2: Draft an Employee Stock Option Scheme (ESOS)
An ESOS is a policy-level document that outlines how the ESOPs work in your startup. Consider this to be the guiding charter of all operational aspects of your ESOP framework. Since no two startups are the same, the ESOS is a customized document that suits your startup’s needs.
Ideally, an ESOS should cover the following:
- Size of the option pool — how many shares do you want to set aside?
- Eligibility criteria — who is eligible?
- Granting process — how does the grant happen?
- Vesting conditions — what are the conditions?
- Exercise price — how much does the employee pay upon exercising his options?
- Exercise conditions — how and when can the employee exercise the options?
Step 3: Complete the Secretarial Matters
If you wish to issue ESOPs, you need to comply with Section 62(1)(b) of the Companies Act of 2013 and the Companies (Share Capital and Debentures) Rules of 2014.
- Convene a meeting to get the board’s approval for creating the ESOS.
- Once the board has approved the scheme, you’ll convene a general meeting to get the shareholders’ approval for allocating ESOPs. Since ESOPs alter the cap table, the general meeting shall pass a special resolution.
- File the MGT-14 form, along with the relevant documentation with the Registrar of Companies (RoC), within 30 days of the general meeting approval (your company secretary can do this). There is no other filing required with the RoC.
- Contact qualifying employees, executives, and directors, and grant the necessary ESOPs.
- ESOPs are only options and not shares. Therefore, there is NO need to increase the authorized share capital of the company at the time of ESOP grants. This happens only when an employee exercises the options.
- Now you are ready to formally grant ESOPs. The ESOS guides the entire process from here on.
What is the Procedure to Issue Sweat Equity
As per the Companies Act, 2013, Section 54 governs the issue of sweat equity along with the The Companies (Share Capital and Debentures) Rules, 2014. Listed companies should also comply with the SEBI guidelines in addition to these rules.
The secretarial matters are:
- Convene a meeting to get the board’s approval for issuing sweat equity.
- Once the board has approved the same, you’ll convene a general meeting to get the shareholders’ approval for issuing sweat equity. Since ESOPs alter the cap table, the general meeting shall pass a special resolution.
- File the MGT-14 form, along with the relevant documentation with the Registrar of Companies (RoC), within 30 days of the general meeting approval (your company secretary can do this).
- Call a Board meeting and allot the sweat equity shares. Finally, file Form PAS-3 to document the allotment of shares.
- You should maintain a Register of Sweat Equity Shares in Form SH-3. This should be available at the registered office of the Company.
The debate on ESOP vs Sweat Equity is an ongoing one. Both these tools have different use cases and are effective in retaining and motivating employees. In both cases, planning the issue of shares, its quantum and valuation are of prime importance. You can download our comprehensive guide on Sweat Equity from here.
At KayOne Consulting, our team of consultants have expertise in guiding you in structuring your ESOPs and Sweat Equity schemes. Schedule a free consultation to talk to one of our experts.