Sweat equity

Most new shares a company issues are sold to raise money. Sweat equity shares are different. The company is not selling them to a stranger for cash. It is handing them to the people who built the business.

Under Section 54 of the Companies Act, 2013, a company can issue shares to its employees, promoters or technocrats as a reward for their contribution. The goal is to keep them motivated to work in the company's interest, not to raise capital.

Even though raising capital isn't the point, sweat equity is still a real share issue. New shares are created and allotted, so existing shareholders end up owning a slightly smaller slice of the company, exactly as with any other fresh issue.

The workbook gives sweat equity a specific job: it helps reduce agency risk, the risk that comes from management and ownership being separate people. Giving key people a real stake in the company is meant to align what is good for them with what is good for every other shareholder.

Meridian Technologies Ltd, an unlisted software company, issues 2,00,000 sweat equity shares to its chief technology officer under Section 54, in recognition of the platform she built over four years. The shares are allotted at a face value of Rs 10, well below the company's last funding-round valuation of Rs 85 per share.

The CTO now holds stock worth Rs 20,00,000 at face value, and roughly Rs 1.7 crore at the funding-round price, without paying cash for it. Every other shareholder's percentage ownership falls slightly to make room for her new shares.

Chapter 2 covers sweat equity in the primary-market section alongside Offer for Sale and Employee Stock Option Schemes. Expect a question testing the Section 54 citation, or one asking why sweat equity is issued when the company does not need the cash.

• Sweat equity is not issued to raise money. The workbook is explicit that raising capital is not its purpose, even though it is still, technically, an issue of new shares.
• Don't confuse it with an Employee Stock Option Scheme. An ESOP gives the employee only an option to buy shares later, usually after a vesting period of more than a year, at a pre-fixed price. Sweat equity is the shares themselves, issued directly, right away.
• Sweat equity dilutes existing shareholders exactly as any fresh share issue does. Its reward purpose does not exempt it from dilution.