Relaxing the rules around issue of sweat equity shares by startups

Introduction

Sweat equity shares are typically shares issued to directors or employees for their know-how. The Companies Act, 2013 (“Act”) also defines[1] them as follows: “such equity shares issued by a company to its directors or employees at a discount or for consideration, other than cash, for providing their know-how or making available rights in the nature of intellectual property rights or value additions, by whatever name called.”

The Ministry of Corporate Affairs (“MCA”) vide its notification dated 5th June 2020 amended Rules 8(4) through the Companies (Share Capital and Debentures) Amendment Rules, 2020 (“Amendment”). Prior to the Amendment, a start-up company could issue sweat equity shares not exceeding 50% of its paid up equity capital for upto 5 years from the date of its incorporation or registration. The Amendment has now revised the length of offer to 10 years and now a start-up has upto 10 years from its incorporation to issue swat equity shares. (It may be noted that ten years is the legally permissible gestation period for start-ups.)

Law relating to sweat equity shares

As per (“Act”), a company cannot in ordinary course may not issue shares at a discount as per section 53 of the Act except as provided under section 54, which carves out an exemption with respect to sweat equity shares subject to the following conditions:

(1)(a)  the issue is authorised by a special resolution passed by the company; (b) the resolution specifies the number of shares, the current market price, consideration, if any, and the class or classes of directors or employees to whom such equity shares are to be issued; (c) where the equity shares of the company are listed on a recognised stock exchange, the sweat equity shares are issued in accordance with the regulations made by the Securities and Exchange Board in this behalf and if they are not so listed, the sweat equity shares are issued in accordance with such rules as may be prescribed. (2) The rights, limitations, restrictions and provisions as are for the time being applicable to equity shares shall be applicable to the sweat equity shares issued under this section and the holders of such shares shall rank pari passu with other equity shareholders.

Unlike in the case of employee stock options, the issuance of sweat equity shares is largely dependent on value addition and not subject to performance metrics or vesting period. This concept had been extensively discussed in relation to the consortium that had won the Kochi IPL, in 2010.

[1] section 2(88)

Complied by Saamir Raketla