In a growing company, a founder needs to consistently find ways to attract and retain the best employees. It goes beyond remuneration and other usual perks. Share-based incentives has been proven tools used by successful founders in doing just that! Read this blog to learn what Sweat Equity shares are and how is it different from Employee Stock Option Plan (ESOPs).

When we talk about issuing shares to employees, Sweat Equity Shares and Employee Stock Options (ESOP) are not foreign words. But as you dig deeper, the difference between the two gets blurred. We’ll tell you the difference between ESOP and sweat equity shares so that you can make an informed decision.

What are Sweat Equity Shares?

Sweat Equity shares are issued in exchange for the contribution of employees to know-how, IPR or similar value additions. Such shares can be issued by a Company at discount or for consideration other than cash. Here, the know-how or IPR can be equivalent to the consideration. The key element here is consideration other than cash.

Employee Stock Options Plan (ESOP)

In ESOP, a pre-defined class of employees are allotted with Options to exercise the shares of a Company in future at a pre-determined price. Such pre-determined price is generally discounted to motivate the employees for equity participation. The Options are conditional to revenue targets or other performance-based terms, known as vesting conditions. Once the conditions are met, the employees can exercise the right to convert the Options into equity shares by payment of the price determined. The ESOPs cannot be issued for consideration other than cash.

stages of ESOP

You might have noticed that Sweat Equity shares are compensation for contributions already made. But the ESOP is motivation to contribute in the long term.

Significance of Share-based Incentive Plans

Early-stage organisations or start-ups are unable to reward the employees in cash or with other monetary rewards. Issuing shares can resolve the issue of liquidity for acquiring know-how or intangibles. In such a case, equity participation creates a sense of partnership for the employees and boosts the morale of the employees to stick with the Company in long term.

Difference between ESOP and Sweat Equity

Particulars Sweat Equity Employee Stock Options Plan (ESOP)
Allotment The employees are allotted the shares. The employees are allotted the Options to convert into Equity Shares. Allotment of Options is termed as Grant of Options.
Stages Direct allotment of shares Grant of Options –> Vesting Period –> Exercise of Options –> Allotment of Shares
Eligible Employees Permanent Employees of the Company (working for at least one year); Director; or Employees or Director of holding and subsidiary Company. Permanent Employees of the Company; Director; or Employees or Director of holding and subsidiary Company.
Eligibility of Promoter or Promoter Group Sweat Equity Shares can be issued to promoters. Companies except DPIIT recognised start-ups cannot issue ESOPs to promoters.
When to issue Sweat Equity can be issued one year after commencement of business. There is no time limit or restriction.
Valuation of Shares The Fair Value of Sweat Equity shares must be evaluated by the Registered valuer at the time of issue. At the time of grant of Options, the Fair Value of shares must be determined by the Registered Valuer.

The exercise price is determined at the discretion of the Board.

Consideration for the purchase of shares Sweat Equity can be issued for cash at a discount or other than cash consideration. The consideration for ESOP must be in cash.
Lock-in period Minimum 3 years from the allotment of shares, helps in retention strategy. No lock-in period. At the discretion of the Company.
Cap of issue In a year, the company cannot issue Sweat Equity for more than 15% of the existing paid-up equity share capital or shares of the issue value of INR 5 crore, whichever is higher. The overall limit shall not exceed 25% of the paid-up capital at any time.

The overall cap for DPIIT recognised start-ups is 50% up to 10 years from its incorporation or registration.

If the Company issues options equal to or more than 1% of its issued capital, the consent of shareholders via separate special resolution must be taken.
Best use case To compensate the employees for their significant contribution in intangibles and value addition. To motivate employees to participate in Company’s growth by the performance-based incentive plan.

To sum it up…

ESOP and Sweat Equity Shares, both can be significant tools to attract the best human resources. The best implementation of these tools is to be decided by the Company. However, implementation of either tool will impact the capital structure of the Company, which would alter the control through voting rights. Therefore, this cautious step must be planned with a professional’s advice. At LegalWiz.in, we provide hassle-free services through a team of experienced professionals so that you can make a wise decision at every step. Connect with us today to get started!