Valuation of Sweat Equity Shares

Raghvendra Sonker

03 Aug, 2022

Section 2(88) of Companies Act, 2013 provides for Sweat Equity Shares issued by employer/owner to its employees and directors at a negligible or discounted consideration, other than cash (in kind). The valuation of sweat equity shares is beneficial for employees and the company as it plays a strategic role in deciding investments for the business. A business enterprise issues shares and equity to raise money and bring expertise into operations without increasing the company’s debt levels.

What are Sweat Equity Shares?

During the early stages of business operations, employees contribute and perform beyond their pay scale for the growth and development of the organisation. No monetary compensation is awarded for this uncompensated work of the employees; instead, the company’s equity is issued in their name. Sweat Equities are shared based on performance and are issued to employees only.

Issuance of Sweat Equity Shares

Section 54(1) of the Companies Act, 2013^[1] provides conditions to be fulfilled by a company to issue the sweat equity shares to their existing employees and directors. The following conditions are:

• A special resolution is passed in the general meeting. The resolutions must consist:
• Number of Sweat Equity Shares
• Current Market Price of the Share
• Consideration
• Classification of the Employees and Directors
• Compliance with the SEBI regulation and details of the listed shares and Stock Exchange;
• If shares are not listed on any of the exchanges, then rules made by the central government are to be followed.

Importance of Sweat Equity Shares

The issuance of sweat equity shares can be beneficial for both employees and companies at the same time. Some of the significances are discussed below:

• In their initial days, most startups or business enterprises cannot incentivise or reward employees with monetary benefits. Therefore company issues sweat equity shares in the name of employees.
• Sweat equity shares are issued to reduce the additional financial burden and to have continued control of the expenses and budget. 
• Employees/ Directors get directly involved in the operations of the company.
• Issuance of Sweat Equity shares can encourage and motivate employees to stay with companies for longer. These issuances can also boost the morale of other employees, increasing the efficiency and productivity of the business operations.
• Employees with sweat equity shares are better equipped to absorb the economic shock and handle pay cuts during challenging times.
• Periodic salary raises can be avoided by issuing sweat equity shares to high-performing individuals.
• The gains on the increase in prices of the shares over the period of time can be enjoyed by the employees/directors, and even dividends are received on the company’s profit.

Valuation of Sweat Equity Shares

In order to determine the value of the intellectual property rights like trademark, patent and copyright, technical know-how, and value additions by the employees, the company appoints a registered valuer to carry out the process of valuation of sweat equity shares (in case of a listed company, a merchant banker is hired, and SEBI registered merchant banker with experience of 10+ years is hired for unlisted companies).

The valuation of sweat equity shares must be prepared in accordance with standard accounting principles and addressed to the board of director/directors of the company. The companies are using different methods to evaluate the fair value of shares. The namely approaches have been consolidated to determine the valuation of intangibles. The valuation of intangibles can ascertain the fair value of shares allocated to employees. By evaluating some factors responsible for the overall improved performance of the company. Those factors are discussed below:

Valuation of Intellectual Property Rights

Analysing the worth of Intellectual Property (IP) is critical for the valuation of Sweat Equity Shares. The value determination of IP is a complex process and requires the help of an experienced registered valuer. The most preferred method of IPR valuation are following;

Cost Method

Under this evaluation technique, the cost of similar Intellectual Property is identified and compared for valuation of Intellectual Property. Example: Cost of developing an IP and analysis of legal protection etc.

Income Method

This is the most common valuation method; under the income method, two parallels are drawn between the expected income after introducing new Intellectual Property in the company and the present situation. The cash flow generated in the past is compared with the future estimation of cash flows.

Market Method

The market-based approach determines the value of intellectual property by accessing and comparing the allocated IP with the transaction of similar IPs between unrelated parties, like determining the fair royalty rate of an Intellectual Property and fair price for sale and purchase of the product.

Valuation of Technical Know-How

If the contents of the technical know-how are closely connected to the employee, only in that scenario it can only be offered to them. Know-how generally means non-patented practical information gained through experience. The transferability of Know-howrequires adequate staff training and codifying methods and procedures to depersonalise and preserve it for future use. The market value of the know-how must be placed in order to evaluate the intangible assets included in the company.

Value Additions

The experiences, skills, specialisation, networking, and leadership of the employees contribute to the management and impact increased efficiency and productivity. This determinant can analyse the changes in the organisational setup achieved through value additions in the company.

Different Models for Valuation of Sweat Equity Shares

• Income Approach Methods
• Stock Value
• Market Approach Methods
• Cost Methods

Note: The above list is not exhaustive, different methods and factors are considered for the valuation of sweat equity shares].

Conclusion

Valuation of sweat equity shares is significant in making informed financial decisions for all the stakeholders. The reliance on the valuation of intangibles like sweat equity shares can’t be solely based on the cost and market approach. Both approaches are significant and often used to determine the value of Intellectual property rights and value additions by the person employed in the company.

Read our Article: Issue of Sweat Equity Shares under Companies Act, 2013