How does an ESOP differ from sweat equity?
An ESOP is an option given to a director, officer, or employee to purchase, or to subscribe for, shares at a future date at a price fixed in advance. A sweat equity share is an equity share issued now, at a discount or for consideration other than cash, for know-how or a value addition.
What is an ESOP?
Section 62(1)(b) allows the company to offer shares to employees under a scheme of employees’ stock option if the shareholders pass a special resolution. For an unlisted company the scheme follows rule 12. There is a minimum of one year between the grant and the vesting. The exercise price is set by the scheme. Until the employee exercises the option and the shares are allotted, the employee is not a shareholder of those shares. A listed company’s scheme also follows the SEBI regulations on share-based employee benefits. Those regulations do not replace rule 12 for an unlisted company.
What is a sweat equity share?
Section 54 allows a company to issue sweat equity shares to its directors or employees, by a special resolution. The consideration is know-how, a right in the nature of intellectual property, or a value addition. The shares may be issued at a discount, or for consideration other than cash. A registered valuer values that consideration. The shares rank with the other equity shares of that class, so they carry the vote those shares carry. They are locked in for three years.
In a year the issue is not more than 15 percent of the paid-up equity capital, or shares of an issue value of ₹5 crore, whichever is higher, and it is not more than 25 percent of the paid-up equity capital of the company at any time. A startup recognised for this purpose may issue a higher portion, within the limit and the period the rules set. The issue is to a director or an employee, including a director or employee of a holding or subsidiary company in India. It is not an issue to a person who is only a consultant.
How do the two differ?
| Point | ESOP | Sweat equity |
|---|---|---|
| What is given now | An option | Shares |
| Price | The exercise price in the scheme | A discount, or consideration other than cash, valued by a registered valuer |
| Waiting period | At least one year before vesting | Three-year lock-in after issue |
| Vote | Only after allotment | From allotment, as equity of that class |
When is the employee taxed?
On an ESOP, the difference between the fair market value on the date of exercise and the price the employee pays is a perquisite, taxed as salary. A later sale is a capital gain, measured from that fair market value. An employee of an eligible startup can defer the tax on that perquisite until the shares are sold, the employee leaves, or 48 months from the end of the relevant assessment year, whichever is earliest. Sweat equity is also taxed as a perquisite to the extent of the discount, and a later sale is a capital gain. The company’s own deduction follows the year in which it records the expense the Act allows.
Frequently asked questions
Four questions cover the Act, voting, a consultant, and an unexercised option.
Does the Companies Act ignore ESOPs?
No. Section 62(1)(b) allows a further issue to employees under a scheme of employees’ stock option, passed by a special resolution, and the rules set the vesting and the price.
Do sweat equity shares have no vote?
No. They are equity shares and carry the voting right of that class. They are locked in for three years.
Can a consultant take sweat equity?
The section allows the issue to a director or an employee, for know-how, intellectual property, or a value addition. A person who is only a consultant is outside that list.
Does an option holder vote before exercise?
No. The option is a right to subscribe later. The person votes only after the shares are allotted.
Sources
Employees’ stock option is section 62(1)(b) and rule 12. Sweat equity is section 54 and rule 8 of the Companies (Share Capital and Debentures) Rules, 2014. A listed company also follows the SEBI share-based employee benefit regulations.