Companies are always looking for innovative ways to compensate and incentivize their employees for the long-term success and growth of the organization and their careers. The two most prominent ways in which companies in India can help in this regard are by issuing shares to the employees, employers, and directors of the company. Shares can be issued in the form of Employee Stock Ownership Plans (ESOPs) and Sweat Equity Shares. Employee Stock Ownership Plans (ESOPs) allow employees to become partial owners of the company by providing them with the option to purchase shares at a discounted rate or sometimes even for free. The idea behind ESOPs is to make employees feel more invested in the company’s future by giving them a direct stake in its success. Sweat Equity Shares, on the other hand, are given as a reward for the non-financial contributions employees make to a company, such as their expertise, skills, or intellectual property. Instead of purchasing these shares, employees receive them in recognition of their significant contributions to the company’s growth.
Both mechanisms are different in their way in their structures, tax implications, legal protection, and the type of contribution they reward. In this blog, we shall understand the meaning of ESOP and Sweat Equity Shares, governing statutes, and the key differences between them.
What is an ESOP?
An Employee Stock Ownership Plan (ESOP) is a tool for employees to buy shares of their employer’s company, often at a discounted price or as part of their compensation package.
As per Section 2(37) of the Companies Act, 2013, ESOP means an option that is given to the directors, officers or employees of a company or of its holding company or subsidiary company or companies to right to purchase or subscribe the shares of the company at a future date at a pre-determined price. ESOPs are designed over time to provide employees with the option of getting stocks in the company that they can exercise at a future date,
Key Features of ESOPs:
1. Stock Option Granting: Under an ESOP, employees are given the option to buy shares of the company at a predetermined price, which is termed “exercise price,”. The price of these shares is mostly less than the market price of the share.
2. Vesting Period: ESOPs usually have a vesting period, which means employees need to stay with the company for a certain period before they can exercise their options.
3. Liquidity: The liquidity of ESOPs depends on the stock of the company being publicly traded or having a mechanism for employees to sell their shares back to the company or in the open market.
4. Eligibility: The following are eligible for receiving ESOPs:
- Permanent employee, whether working inside or outside India.
- Full-time or part-time directors
- Permanent employee or director of the subsidiary company, whether inside or outside India.
- Permanent employee or director of the holding company or the associate company.
5. Ineligible: The following are ineligible for receiving ESOPs:
- Independent Directors
- Promoter of the company
- An employee who is a promoter of the company
- A director who holds more than 10% of the company’s outstanding equity shares, whether directly or indirectly.
- A director who holds more than 10% of the outstanding equity shares of the company through its relative. It does not matter if the director holds the share directly or indirectly.
What are Sweat Equity Shares?
Sweat Equity Shares are the kind of shares that are issued by a company to its employees or directors in exchange for their intellectual contributions or hard work (often referred to as ‘sweat’) rather than for cash or capital.
As per Section 2(88) of the Companies Act, 2013, sweat equity shares are those issued by a company to its directors or employees at a discount or for any other consideration. The consideration cannot be cash, though, for their know-how and rights in the nature of intellectual property or value addition to the company.
Key Features of Sweat Equity Shares:
1. Sweat equity is issued to employees for their skills, knowledge, and time invested in the company.
2. No Cash Involved: Unlike ESOPs, which involve employees buying shares, sweat equity shares are given to recipients for free or in exchange for their hard work and contribution.
3. No Cash Consideration: While issuing sweat equity shares, the company cannot take cash as consideration for shares. It can be anything, but not cash.
4. Shareholder Rights: Sweat equity holders receive the same rights as other shareholders, such as voting rights and participation in dividends.
5. Specific Categories: Sweat equity is only awarded to key individuals who have made a significant contribution to the business.
6. Eligibility: The following are eligible for holding sweat equity of the company:
- Permanent employee of the company, whether working inside or outside India.
- Whole-time Director or Part-time Director
- Permanent employee or director of the subsidiary company inside or outside India.
- Permanent employee or director of the holding company inside or outside India.
Key Differences Between ESOPs and Sweat Equity Shares
ESOPs and Sweat Equity Shares differ in the following ways:
| Difference Type | ESOPs | Sweaty Equity |
| Object | The main objective of ESOPs is to motivate employees by giving them an opportunity to become partial owners of the company.
Employees get the opportunity. This tool enhances employee retention and motivation, as employees benefit directly from the company’s success. |
Sweat equity shares are issued to reward employees for their special contributions, such as creating intellectual property or significant operational work, which might not otherwise be adequately compensated with regular cash salaries. |
| Regulatory Framework | ESOPs are governed by the Securities and Exchange Board of India (SEBI) guidelines for listed companies and the Companies Act 2013 for unlisted companies.
Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014, governs the procedure for issuing an ESOP. |
Sweat equity shares are regulated by the Companies Act 2013 and are subject to the guidelines issued by SEBI and the Ministry of Corporate Affairs.
Rule 8 of the Companies (Share Capital and Debentures) Rules, 2014 governs the procedure for issuing a Sweat equity. Sweat Equity shares can only be issued after the approval of the shareholders through a special resolution.
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| Nature of Shares | ESOPs are stock options granted to employees, giving them the right to buy shares in the company at a pre-set price after a certain vesting period.
The consideration for issuance of these shares is cash only. |
Employees receive sweat equity shares in return for their tangible or intangible contributions to the business; no initial cash outlay is necessary. These shares are usually given to important people who contribute to the creation of the company’s wealth.
The consideration for issuing these shares cannot be cash. Other than cash, it can be anything. |
| Mode of Acquisition | Employees acquire ESOPs by purchasing shares at a discounted rate or predetermined price. This means employees need to use their own money (or opt for financing through the company) to buy the shares. | Sweat equity shares are issued to employees or directors for free or at a very low price in recognition of their efforts and contributions. There is no purchase price involved, as the shares are granted in exchange for ‘sweat’. |
| Vesting and Exercise | ESOPs come with a vesting period, which is the duration an employee must work at the company before they can exercise their options to purchase shares. Once vesting that period, the employee can choose to exercise the options at the agreed price. | There is no vesting period involved in sweat equity shares, as these shares are immediately available to the recipients. |
Conclusion
In conclusion, both ESOPs and Sweat Equity Shares serve as effective tools to reward and motivate employees, but they operate in distinct ways. While ESOPs are more geared towards offering employees a direct stake in the company’s ownership and promoting long-term engagement, Sweat Equity Shares are a recognition of the intellectual and non-financial contributions that employees or directors make to the company. Each system plays a unique role depending on the type of contribution, the company’s stage, and its overall compensation strategy. By understanding the differences between these two options, businesses can better design incentive plans that foster growth, attract talent, and align the interests of employees with those of the company.
FAQs
1. What is the main difference between ESOPs and Sweat Equity Shares?
ESOPs allow employees to purchase shares at a discounted price, while Sweat Equity Shares are awarded in recognition of non-financial contributions like intellectual property.
2. Are ESOPs available to all employees?
No, ESOPs are generally offered to permanent employees, directors, and key management, with certain exclusions.
3. Can Sweat Equity Shares be issued for cash?
No, Sweat Equity Shares cannot be issued for cash; they are provided for intellectual property or other non-cash contributions.
4. Do ESOPs require employees to stay with the company?
Yes, ESOPs usually have a vesting period, meaning employees must stay with the company for a certain period.
5. Are Sweat Equity Shares transferable?
While they may be restricted from immediate transfer, the transferability of Sweat Equity Shares depends on the company’s policies.
6. Do Sweat Equity Shares come with voting rights?
Yes, holders of Sweat Equity Shares enjoy the same shareholder rights as other equity holders, including voting rights.
7. Is a special resolution required to issue Sweat Equity Shares?
Yes, a special resolution from the shareholders is required before a company can issue Sweat Equity Shares.
