Sweat Equity: What's it? How?

The nitty-gritty of sweat equity
Amitabh Singh (Source: The Hindu BusinessLine)
Sweat equity, very literally put, are equity shares that the company issues to an individual in consideration of his services, knowhow or any other value addition that the company has benefited from. These equity shares can be issued free of charge or at a concession to their prevailing value. Here is a quick Q&A on the subject:

Are "sweat equity" the same as "stock options"?
Not exactly. They are similar to the extent that both are means of providing non-cash incentive or compensation to individuals. However, sweat equity, as widely understood, are real shares allotted to individuals upfront.
Stock options, on the other hand, is merely a right given to the individual to acquire shares of the company at a future date at a pre-agreed price.
Cognisant of the inherent differences between the two, the Securities and Exchange Board of India (SEBI) has issued separate guidelines for sweat equity and stock options.
These guidelines are applicable to all Indian listed companies.
Are there any guidelines for sweat equity shares in case of unlisted companies?
Yes. Sweat equity is governed by Section 79A of the Companies Act. To regulate sweat equity in case of unlisted companies, the Department of Company Affairs (DCA) has issued the "Unlisted Companies (Issue of Sweat Equity Shares) Rules, 2003".
To whom can sweat equity be issued?
In a broader sense, sweat equity can be issued to anyone who has rendered services to the company. Sweat equity can be issued to an employee, consultant or a vendor. That is the reason start-up companies use sweat equity as currency to pay for services that they cannot pay for in "hard" cash.
However, in India, as per SEBI and DCA regulations, sweat equity shares can be issued only to employees or directors.
Why would an employee or any other person accept shares instead of cash, especially from a start-up company whose future prospects are uncertain?
The whole concept of using company shares as remuneration or reward has its origins in the famous Silicon Valley. Employees and vendors joined together to build an ecosystem that allowed technology start-ups to access talented resources and high quality services in return for company stock. Many of these start-ups are Fortune 100 companies and many of these employees who took stock instead of cash are millionaires, if not billionaires.
At the same time, all start-ups do not go on to become a Microsoft or HP. If the company fails, the stocks are worthless and that is the risk-reward judgment an individual has to grapple with.
(The author is Tax Partner and National Leader, Human Mobility Services, Ernst & Young.)

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