Sweat Equity Regulations for Start Ups

In a commendable decision by the Securities Exchange Board of India (SEBI), relaxations have been extended to new-age technology firms in terms of sweat equity rules. Let us have a look at the present framework and the changes made by SEBI.

WHAT IS SWEAT EQUITY?

Section 2(88) of the Companies Act 2013 defines sweat equity shares as those equity shares that are issued by a company to its directors or employees, on discounted rates or for any consideration other than cash, like for providing know-how or making certain intellectual property rights available or for value additions.

A company is allowed to issue sweat equity shares to the follow group of persons:-
  1. Individual
  2. Private Company
  3. Public Company
  4. Section 8 Company (Charitable Company)
  5. Listed and Unlisted Companies
As per Section 2(88) of the Companies Act, sweat equity shares can be allotted only to directors of the company or the company’s employees. For this purpose, employee has been defined under Rule 8(1)’s Explanation (i) of the Companies (Share Capital and Debentures) Rules, 2014. It means that an employee is a person who is:-
  1. A permanent employee of the company working in India or outside India for a term of at least one year, or
  2. A director of the company, whether full time or not.
  3. An employee or a director as defined above of a subsidiary of the company in India or outside India, or of the holding company of the company.
Employees are mostly given sweat equity shares for value addition which has been defined in Explanation (ii) of Rule 8(1) of the Companies (Share Capital and Debentures) Rules 2014. It means an actual or anticipated economic benefit derived or expected to be derived by the company from an expert or profession for providing his know-how or making available any intellectual property right to whom sweat equity shares are issued rather than paying consideration or is included in the normal renumeration payable under the contract of employment, in case of an employee.

Sweat equity shares are mostly issued in the form of an incentive to the directors or employees for their extraordinary work in a particular task or project or for achieving the desired output for the company. Through sweat equity, equity rights are given to the employees in the company, making them a part of its ownership at a discounted rate as compared to the market rate. Because of being a member of the company, the employees are further motivated to work towards its profit.

Section 54 Companies Act 2014 along with the Companies (Share Capital and Debentures) Rules 2014 apply to issue of sweat equity by unlisted companies while for listed companies, Companies Act along with SEBI Regulations are applicable.

Unlimited shares cannot be allotted in the form of a sweat equity scheme. A company should keep in mind the limit of authorized capital of the company, including paid up capital, before allotting sweat equity. The sweat equity scheme’s value shouldn’t exceed the value of authorized capital held by the company and this limit can be extended only after increasing the authorized capital before the issue of the sweat equity scheme.
 
PROCEDURE FOR ISSUE OF SWEAT EQUITY SHARES

A complicated and broad procedure needs to be undertaken in order for the sweat equity shares to be issued. The following are the steps that need to be followed by the company planning to issue sweat equity shares:-
  1. Convening and holding a board meeting for considering the proposal for issue of sweat equity shares and for fixing the date, time, place and agenda for the general meeting for passing a special resolution for the same.
  2. Issuing notice in writing to the shareholders for the general meeting alongwith explanatory statement regarding the scheme. It is to be annexed to the notice as per Section 102 of the Act and must contain the following:-
  3. Date for the board meeting in which the proposal for issue of sweat equity shares was approved.
  4. Reasons or justification for issue of sweat equity shares.
  5. Class of shares under which scheme intended.
  6. Class or classes of directors or employees to whom equity shares are to be issued.
  7. Principle terms and conditions on which sweat equity shares will be issued
  8. Time period of association of persons with the company to whom sweat equity shares will be issued.
  9. Names of directors or employees to whom the sweat equity shares and their relationship with the key managerial personnel and the promoters
  10. Price at which sweat equity share proposed to be issued
  11. Consideration including other than cash to be received for sweat equity shares
  12. Statement conforming to the applicable accounting standards
  13. Diluted earning per share pursuant to the issue of equity shares, calculated in accordance with applicable accounting standard.
  14. Convening general meeting and passing special resolution
  15. Filing the resolution with form MGT14 within 30 days of passing the same
  16. Calling the board meeting and allowing sweat equity
  17. Filing Form number PAS-3 within 30 days of passing of the board resolution
  18. Maintaining a record of sweat equity shares issued and particulars of such shares
  19. The register mentioned above shall be at the register office of the company
  20. The entries in this register shall be authenticated by a company secretary or by such purpose authorized by the board.
For companies or directors failing to adhere with provisions for sweat equity shares, there are no direct penal provisions. General provisions have been provided for penalty. If any company or its officer or any other person contravenes the provisions of the Companies Act 2013 or the rules made thereunder, the such a company or person shall be punishable with a fine which may extend to Rs. Ten Thousand and where there is continuing contravention, the fine can be extended to Rs. One Thousand for every day when the contravention continues.
 
HOW ARE STARTUPS DEFINED UNDER THIS NEW PROVISION

Start-ups are an important element of Indian Government’s flagship initiative “Start-up India” which aims at building and boosting a strong ecosystem for the growth of start-up business which would enable growth of economy and generate large scale employment opportunities.

A start-up can be registered as a private company, a registered partnership firm or a limited liability partnership. And for a start-up to be recognized as one and given the benefits, the time period is limit to 10 years from the date of incorporation of the entity in question. This validity of 10 years is assured by the Start-up Certificate issued by the Department for Promotion of Industry and Internal Trade. The turnover for an entity to be considered as a start-up should be limited to Rs. 100 Crore for any financial year since the incorporation or registration of the entity.

Not all activities carried out by entities are considered as start-ups. For an entity to qualify as a start-up, it should be working towards innovation, development or improvement of products or processes or services, or any business model which shows high potential of employment generation or wealth creation.

There are several benefits or relaxations provided to the start-ups, which are mentioned as follows:-
  1. Simple Registration- Government of India has enabled the registration of start-ups through mobile app and a website and anyone interested in incorporating a start-up entity shall just upload a simple form on the website along with the required documents.
  2. Access to Funds- Government of India, for easy access of funds to start-up entities, provides guarantee to lenders for encouraging banks and financial institutions to provide venture capital to the start-up firms.
  3. Tax Holiday- Strat-up entities are exempt from paying tax for 3 years, provided they get the required certification from Inter-Ministerial Board (IMB) under Section 80-IAC of the Income Tax Act.
  4. Research and Development Facilities- In pursuit of providing better access to research and development facilities to the start-up entities, seven new Research Parks have been set up by the government.
  5. Easy Winding Up- The law provides for easier winding up of a start-up company, within 90 days as per the provisions of the Insolvency and Bankruptcy Code 2016.
  6. Patent Application and IPR Protection- Fast-track modes for patent application with up to 80 per cent rebate in filing patent is provided to the start-up entities.
  7. Public Procurement Norms- The public procurement norms for start-ups are relaxed as exemption regarding requirement of earnest money deposit, prior turnover and experience requirements in government tenders is provided.
  8. SIDBI Fund- Alternate Investment Funds are provided to start-ups for funding their venture.
 
START-UPS AND SWEAT EQUITY

It was in 2020 that Indian government had allowed the Indian start-up entities to issue sweat equity schemes within the first 10 years of their incorporation or registration. The change was brough through an amendment to the Companies Act 2013, which aims at empowering start-ups gain more talented experts and members and to retain them by giving them a part of the equity of the company.

The start-up entities which are incorporated as private companies can issue sweat equity shares to their directors and employees against any intellectual property rights or any technological know-how provided by them. This means that in most cases, the sweat equity shares issued by start-ups are limited to new age technology start-ups as they involve the highest use of know-how and intellectual property.

The law, post the amendment, has allowed even start-ups to issue sweat equity shares at a discounted rate or for a consideration other than cash. Previously, the limit for issuing sweat equity shares was 5 years, which has now been extended to 10 years. The move is a laudable act on the part of the government concerning that the Indian start-ups are facing a downward curve in terms of revenue earning, funding and liquidity due to economic slowdown caused by the COVID-19 pandemic and the lockdowns that followed. This has also led to a decline in consumption patterns which is likely to affect start-ups for a longer duration.

The amendment was made via a notification issued by the Ministry of Corporate Affairs which said that the entities which qualify as start-ups within the 2019 policy of the Department of Promotion of Industry and Internal Trade shall be allowed to issue sweat equity shares up to 10 years from their date of incorporation or registration.

Back in 2016, the Indian government had raised the limit of sweat equity for start-ups from 25 per cent to 50 per cent of the total paid up capital. The relaxation was provided as a move to improve the incentives for innovators and entrepreneurs working to boost the Start-up Indian Initiative.

A committee was set up by the Government of India in this regard, to review the issues arising out of the implementation of the then newly enacted Companies Act 2013, and one of the suggestions of the committee was regarding raising the limit of sweat equity for start-ups as against paid up capital.

As per the Companies Act, there is a restriction on issue of Employee Stock Ownership Programs to promoters or promoter directors, eve if they are considered as employees of the company. This was a restriction for the start-up firms as they found it difficult to incentivize their funders and directors for their skills, know-how and availability of intellectual property rights.

This extension of limit is a respite for the start-up owners to incentivize their employees and directors to retain talent in their newly developed entities.
 
SWEAT EQUITY RULES RELAXED FOR NEW-AGE TECHNOLOGY START-UPS

Securities Exchange Board of India is the market regulator in India which is responsible for framing rules and regulations for trading in shares and debentures. The laws pursuant to this are the Companies Act 2013, the Companies (Issue of Shares and Debentures) Rules and the SEBI Act along with others.

The new rules notified by SEBI have relaxed the quantum of sweat equity that can be issued by the new-age technology companies listed on the Innovators Growth Platform (IGP).

The market regulatory body has merged the Share Based Employee Benefits Regulations 2014, also known as the SBEB and the SEBI (Issue of Sweat Equity) Regulations 2002. Both these legislations deal with the compensations provided to employees. The new, combined and single regulation formed is the SEBI (Share Based Employee Benefits and Sweat Equity) Regulations 2021.

As per the revised regulations, in case of IGP-listed companies, the yearly limit of sweat equity shares issued will be up to 15 per cent, while the overall limit will remain 50 per cent of the paid-up capital at any time, as per the amendment brought forth in 2016, The notification states that the companies trading on mainboard can issue annual sweat equity shares up to 15 per cent of total paid up capital but the overall ceiling shall remain capped at 25 per cent of the paid-up capital.

As for the limit of issuing sweat equity shares, a start-up can issue shares till 10 years from the date of the entity’s incorporation or registration.
The notification read that the sweat equity shares to employees can be issued to promoters or promoter groups and shall be approved by a way of resolution passed by simple majority of shareholders in general meeting.

With the new rules, the companies have been provided a greater level of flexibility in switching the administration of the company’s schemes from trust route to direct route and vice-versa, with approval of the shareholders. However, this flexibility is subject to conditions, that the switch shouldn’t be, in any case, against the interest of the employees.

SEBI also noted in the notification that the time period for appropriating unappropriated inventory of trust has been extended from existing one year to two years, subject to approval of the compensation or nomination and renumeration committee for such extension.

The question regarding minimum vesting period or lock-in period for all share benefit scheme was also discussed and it has been dispensed with in event of death or permanent incapacity of an employee, as defined by the company.

As for sweat equity, the lock-in period of shares and its pricing formula shall be consistent with the ICDR (Issue of Capital and Disclosure Requirements) Regulations. The amendment came after the board of SEBI approved a proposal to this regard earlier this month.

Continuing as per previous norms, sweat equity shares issued by a listed company shall be eligible for listing subject to their issuance being in accordance with the newly formulated regulations. These measures have been brought in keeping in mind the increasing number of start-up entities applying for public listing, like Zomato and PayTM.

These amendments and relaxations have come forth as a result of a seven-member group constituted by SEBI in July which made several policy recommendations in its reports, including considering the eligibility of non-permanent staff members to receive share-based employee benefits.
 
CONCLUSION

New and innovative start-ups in India are making their way in the market, increasing employment possibilities for the currently unemployed masses in the Indian economy. However, though the start-ups are boosting economic growth, they come with their share of financial instability, which has been aggravated by the COVID-19 pandemic.

To retain employees and talented members in the start-up entities, these relaxations in sweat equity rules is a silver lining for start-ups. The issue of sweat equity shares will allow start-ups to raise funds without raising debt and retaining their trustworthy staff, both at the same time.
These relaxations will not only help the start-ups but also help the economy gain stability during the time of instability caused by the pandemic.