Issuance of Sweaty Equity is an important tool of Human Resources management. In the milieu of a recuperating economy from financial meltdown ESOPS and Sweat Equity are playing a vital role in overcoming attrition cusps and poaching by rival business organisations. There is an inextricable relationship between start up ventures and Sweaty Equity. Given that most of the key people come together sharing their IPR merits; technical, scientific and research know- how and management credentials, appreciating their risk and the opportunity cost of their factors, they are included in the promoter group of the company and offered sweat equity or ESOPS at a priceless than the existing market value. More often than not transactional legal practitioners, management executives and other corporate stake holders are embroiled in the confusions surrounding the modus operandi of sweat equity issuance. The limitations backing the conservatism of sweat equity issuance can be ascribed to confabulating recipient recognition process, uneasy tax treatment and the procedural inconsistencies. Given that the common denominator of regulatory regime across the world is discordant and least to say a uniform methodology in place for sweat equity issuance is oblivious, an attempt has been made by the authors to deliberate into the intercracies surrounding the convolutions. The authors have chosen the jurisdiction of India, United States and Japan. U.S.A's prototypical reference and burgeoning technical soundness coupled with sound venture capitalism of India and Japan has inspired the jurisdictional choice of the authors.
Part II recognises the role and importance of intellectual property as a consideration for according sweat equity. The succeeding part discusses the major obstacles plaguing defective and abortive Sweat Equity issuances. Part III of this paper elucidates the controversy surrounding the Indian Premier League stemming from the scheme of sweat equity issuance in connection with right recipients. Part IV elaborates and details the regulations governing sweat equity issuance in India, U.S and Japan. Part V discusses the tax treatment of sweat equity in the above said jurisdictions. Part VI deals with the concluding remarks of the authors.
Intangible Rights and Sweat Equity
Sweat equity issuance presupposes tendering of intellectual property among others. Sweat equity is the labour justification of recognising the ownership rights which is based on the principle that the creator of intellectual property must be morally conferred its ownership. Human intellect and their contribution to industrial enterprise have been recognized in modern corporation forms. Sweat equity is a result of the efficient encouragement of give-away between the human capital provider viz. entrepreneur, and the monetary capital provider, viz. venture capitalist. If one party feels too much risk, the other will hesitate to invest his capital. To maximize each party's payoff, both parties need to bargain with each other to encourage each other to invest their respective monetary and human capital. It is a characteristic two-sided agency predicament. It is a practical arm's length business deal. It is very important take into cognizance that the deal has been arranged not to transfer value without any cause and consideration.
The phenomenon of employees contributing to an organization being remunerated through shares is no novelty. This concept of using company shares as remuneration or reward owes its origin to the celebrated Silicon Valley of United States of America. Employees and start- ups came together to build a setup that permitted technology start-ups to access superior quality resources and high end value services in return for the company shares in Silicon Valley. Many of these start-ups are found in the coveted Fortune 100 list. In India, the concept of issuing sweat equity shares was started by Infosys. Sweat Equity Shares are given to the employees at a discounted rate of market value. The whole idea behind giving Sweat Equity Shares is to make the employee feel that he/she is a part owner in the company. When employees feel that their company has their own funds invested in it, they get better motivated and work more earnestly towards company's progress. The Companies Act was amended through the Companies (Amendment) Act, 1999 passed to give effect to this extent and Section 79A was inserted to recognize IPR contribution. The Act allows equity shares to be issued for IPR contributed to the company either by the promoter or any other person. IPR contribution is part of the modicum for evaluation process in connection with Sweat Equity Shares issuance rules.
It is to be noted that there exists major differences between ESOPs and Sweat Equity, unfortunately they are used inter changeably. At this juncture it is sine qua non to bring the differences to limelight. Presently ESOPs are mostly used to buyback the share of a retiring employee and as an incentive scheme for them. ESOPs can also be used for financing in various areas such as financing expansion, when going for acquisition, creating a new division. The basic purpose of ESOPs for many companies is to provide employee benefits or incentives. Although the ESOPs and Sweat Equity are issued to encourage the work and hardship of employees in the company but there are major distinctions between the two as Sweat Equity involves the granting of shares at discount or without monetary considerations whereas ESOPs involves granting of option to purchase share at predetermined price given to employees. Sweat Equity can be issued to the promoters of the Company whereas ESOPs cannot be issued to the promoters or promoter group. Sweat Equity comes with a minimum lock-in period of three years whereas no such lock in period is attached to ESOPs in Indian context.
The Authors in the succeeding parts of this paper would like to make a threadbare analysis prototypically of the intricacies involving issuance of Sweat Equity namely recognition of right recipients, incongruous tax treatments and the procedural inconsistencies.
Recognition of Recipients - A Recent Controversy
Sweat Equity and Employee Stock Option Scheme is being increasingly given by multinational companies to their employees recognising their talent and value addition to the organisation. In general terms, sweat equity is defined as the increase in the equity by the labour of the owner or equity created through labour. It is an instrument to convert the labour income into investment of the organisation. However, in the absence of tangible legal precedents the issuance procedure has come under dark clouds. It is to be noted that absence of well defined criterion to recognise right recipients in major jurisdictions including India has proven noxious. The nitty-gritty of sweat equity issuance has thronged controversies in the recent past. The recent controversy involving Sunanda Pushkar and Shashi Tharoor of India is a case in point.
Indian Premier League (IPL) has created an unprecedented interest among cricket enthusiasts across the world. IPL emerged when the brawl between the Board of Control for Cricket in India and its alter ego Indian Cricket League kicked off, which finally lead to the oblivion of Indian Cricket League from the scene. Global sports salaries review places IPL next to the National Basketball Association in terms of players' honorarium. Presently it consists of ten teams and players from different countries. Noteworthy IPL players include Shane Warne (Rajasthan Royals), Sachin Tendulkar (Mumbai Indians), Ricky Ponting (Kolkata Knight Riders), Andrew Symonds (Deccan Chargers) and Muttaiah Muralidharan (Chennai Super kings).
It is not just the Cricket enthusiasts who have been too finicky about IPL; India Inc. too has an intricate relationship. It can be noted that major Indian corporate houses own IPL teams. Mumbai Indians, a team representing the State of Maharashtra is owned by the renowned Mukesh Ambani Group of Reliance Industries fame. If Vijay Mallya of United Breweries and Kingfisher Airlines owns the Bangalore Royal Challengers team, the south- Indian industrial magnates India Cements owns the Chennai Superkings team. It has almost become a status symbol for India Inc. to own an IPL team. India Inc. has gone to the extent of unsuccessfully bidding at unmerited higher valuations for the teams.
Of all that happened in the IPL saga, the bidding process for IPL Cochin team created controversies and opened Pandora's Box. Rendezvous Sports World, a consortium of prospective bidders made a successful bid to procure the ownership of the IPL Cochin team. Rendezvous alleged that the chairman of IPL, Mr. Lalit Modi, had breached confidential information as regards the disclosure of the share holding pattern of the Rendezvous Sports World which owns the IPL team of Cochin by publicly disclosing them through his tweets. It is to be noted that, the Member of Parliament and then the Minister of State for External Affairs, Mr. Shashi Tharoor who hails from the Indian state of Kerala played a vital role in securing the bid for IPL Cochin team. As per the tweets and the information provided by Lalit Modi, Rendezvous Sports planned to disburse twenty five percent of the shares freely. It was further found out that one Ms. Sunanda Pushkar, a close associate of Shashi Taroor had received 19% sweat equity shares by the Rendezvous Sports World Ltd. Due to the confirmed nexus between Shashi Taroor and Sunanda Pushkar, the former had to step down from the ministry due corruption charges and abuse of his ministry. This created a tumultuous debate, as to who all can be the lawful recipients of sweat equity. Sunanda Pushkar, a Dubai based event management executive contended that, the same was awarded to her recognizing her advice and counselling in building the brand equity of the IPL Cochin Team. Vacuum of well defined criterion and bench marks in connection with right recipients has derailed and aborted the issuances procedure.
Regulatory Regime
India
4.1.1 The Companies Act, 1956
Issuance of Sweat Equity is governed by the SEBI (Issue of Sweat Equity) Regulations, 2002 and the Companies Act (The Act), 1956. Section concerning issuance of Sweat Equity in the Companies Act, 1956 opens with a non- obstante clause. Further the Act, mandates that a Company issuing sweat equity must strictly abide by the provisions of section 79A, notwithstanding anything contained in section 79. At this point it would do well to understand who an employee is and what value addition can he contribute for the purpose of issuing sweat equity. While issuing Sweat equity shares of a class of shares, a Company has to fulfil certain conditions. Under the said section, the Company has to pass the same by a special resolution in the general meeting. The resolution must categorically and unambiguously contain information as regards the quantum of shares to be issued, consideration if any and the market value of such shares and class or classes of Directors or Employees receiving such shares. The provision mandates that a Company to issue the sweat equity shares must have completed one year of business on the date of issuance.
Listed and Unlisted Companies - Regulatory Matrix
All listed companies intending to issue sweat equity shares have to comply with the Securities and Exchange Board of India (Issue of Sweat Equity) Regulations, 2002. Unlisted companies intending to issue Sweat Equity are governed by Unlisted Companies (Issue of Sweat Equity) Rules, 2003
Apart from being applicable to listed companies, the SEBI (Issue of Sweat Equity) Regulations, 2002 ( the Regulations) is applicable to unlisted public companies only at the time of, such companies coming out with initial public offering and intending listing of its securities on the stock exchange, in connection with issuing sweat equity shares. Unlisted companies to whom the regulations are applicable must mandatorily comply with the Issue of Capital and Disclosure Requirement Regulations, 2009. A Company intending to issue sweat equity shares pursuant to clause (a) of sub section 1 of section 79 A of the Companies Act, 1956 must do so by adducing an explanatory note pursuant to section 173 of the Act. It is to be noted that all regulations, limitations and restrictions applicable on equity shares shall be applicable on all sweat equity shares.
The Securities and Exchange Board of India ("SEBI") has the authority to conduct an investigation or to inspect the books or accounts of the company in respect of any contravention of the provisions of the Regulations. SEBI is also authorized to initiate criminal prosecution by filing a complaint in writing in a court. If it is found that the company has contravened the provisions in regard to the issuance of sweat equity, it can be restrained from issuing further sweat equity.SEBI also has the authority to ask the person to whom the sweat equity is issued to be divested of it.
All Unlisted Companies are governed by Unlisted Companies (Issue of Sweat Equity) Rules, 2003. The definition of an employee has been provided under the rules. It elucidates that an employee includes a person working permanently for the company in or outside India and the Directors of the company. It further defines value addition as the anticipated economic benefit derived out of the intellectual property, professional excellence or technical knowhow of the employee. Further such employee, to whom sweat equity is issued, must not have received any other consideration. Such consideration must not be paid for or not included in the normal salary payable to an employee under an employment agreement and monetary consideration to a non employee.
United States of America
The Model Business Corporation Act, 1984 elucidates the modus operandi for the issuance of Sweat Equity in United States. It would be very pertinent to note that the states in United States of America have different Corporation legislations. Nevertheless, they all concur with the requirement of the Model Business Corporation Act, 1984. As the name suggests it acts as a blueprint in drafting corporation legis lations.
Under the Model Business Corporation Act, 1984, a corporation can issue rights, options, or warrants for the purchase of its shares or other securities. In this regard the board of directors shall consider (i) the terms upon which the rights, options, or warrants are issued and (ii) the terms, including the consideration for which the shares or other securities are to be issued. The authorization by the board of directors in this regard constitutes authorization of the issuance of the shares or other securities for which the rights, options or warrants are exercisable. The conditions in issuing the issue rights, options, or warrants for the purchase of its shares or any other securities include: (1) preclude or limit the exercise, transfer or receipt of such rights, options or warrants by any person or persons owning or offering to acquire a specified number or percentage of the outstanding shares or other securities of the corporation or by any transferee or transferees of any such person or persons, or (2) invalidate or void such rights, options or warrants held by any such person or persons or any such transferee or transferees.
The Model Business Organization Act, 1984 authorizes imposing restrictions in issuance of Shares. In this regard it endorses the articles of incorporation, bylaws, an agreement among shareholders, or an agreement between shareholders and the corporation to impose restrictions on the transfer or registration of transfer of shares of the corporation. It is to be noted that the restrictions discussed shall be applicable only when the privity of shareholders to the contract or understanding or agreement exists. A restriction on the transfer or registration of transfer of shares is valid and enforceable against the holder or a transferee of the holder if and only if its existence is noted conspicuously on the front or back of the certificate. The Process seems to be terse and free from superfluity of procedures.
Japan
The Japanese Law does not consider sweat equity as a good practice carried out by entrepreneurs or venture capitalist. Therefore it discourages the same by having an unfavoured law. Japan's present corporation law is based upon the Corporations Code implemented in 2006. Under Japanese law the basic types of companies include: general partnership, limited partnership, limited liability partnership, company and limited liability company (LLCs). Under Japanese corporate law issuance of sweat equity is not allowed in limited liability organizations, including both stock corporations and LLCs. However, it permits sweat equity by general partners in partnerships. In this regulatory milieu, it goes without saying that the practise and process of issuance of Sweat Equity in Japan has swindled downwards.
Structuring a Sweat Equity Deal
For the purpose of brevity and convenience, the deal structuring of Sweat Equity shares has been anatomised in this part. It goes without saying that Sweat Equity deals are great for companies that are cash deficient. Nevertheless, Sweat Equity issuance cones at a higher price. The value of the equity taken is 7 to 10 times the value of the cash equivalent for the purpose of valuation. This portion is high, this can be ascribed to the fact that majority of sweat equity deals with small companies (esp. start-ups) generate no (that is, 0) return.
DEAL BASICS
Contract value is determined (10K this example)
You pay 10% cash up front (1K)
The remainder is converted to sweat equity
The sweat equity is valued by
1. Expected payback/‟exit‟ in 3 to 5 years
2. It offers a PE/VC style return of 20% pa
3. It allows for risk and deal failure, assuming that
2 out of every 3 sweat equity deals returns zero
TYPICAL DEAL SUMMARY
Contract value: 10
Amount paid as cash (10%) (1)
Remainder to sweat equity 9
Expected time to exit‟ 5 years"
Target rate of return 20%
Expected success ratio (1:3) 33%
Year 0 1 2 3 4 5
Amount 9.0 10.8 13.0 15.6 18.722.4
Therefore, a sweat equity deal on a 10K contract breaks down as:
Contract value 10K
Cash paid 1K
Value of sweat equity 22.4 ÷ 33% = 67.2=
Therefore a 10K contract will cost a start-up roughly 70K in sweat equity. With established firms the risk of failure is much lower, so the success ratio is attuned downwards, or in some cases completely eliminated. Corporate Executives should also bear in mind that the value given is the "profit" of the deal, which is not invariably the same as the face value of the equity shares.
V. Tax Treatment of Sweat Equity Shares
5.1. India
Tax liability for income is determined by the Income Tax Act, 1961 ("the Tax Act"). The Finance Act, 2007-2008 has added sweat equity to the definition of fringe benefits. Fringe Benefit Tax (hereinafter 'FBT') refers to any consideration of employment by way of any privilege, service or any free concessional ticket provided to the employee or any specified security or sweat equity shares allotted or transferred, directly or indirectly, by the employer free of cost or at a concessional rate to his employees. Sweat equity shares for the purpose of taxation is defined as equity shares issued by a company to its employees or directors at a discount or for consideration other than cash for providing the know-how or making available rights in the nature of intellectual property rights or value addition. The inclusion of sweat equity within the ambit of fringe benefits means that the company will be taxed at the rate of 33.99% for issuing the sweat equity. Taxation of sweat equity shares presupposes its valuation. Further valuation of sweat equity is ascertained on its fair market value. On October 23, 2007 the government issued a notification ("the Notification") explaining the method to calculate the fair market value of the sweat equity shares.
Valuation Scheme for Listed Companies
A company listed on a recognized stock exchange on the date of vesting of option, the fair market value shall be the average of the opening price and closing price of the shares on the date of vesting on the said recognized stock exchange. If the stocks are listed on more than one stock exchange on the date of vesting of option, the fair market value shall be the average of the opening and the closing prices in the stock exchange where the shares have shown the highest trading must be considered. However, if there is absence of trading on any stock exchange on the day of the vesting of option, the fair market value be the closing price of the shares on any recognised stock exchange on a date closest to the date of vesting of the option and immediately preceding such date or the closing price of the shares on a recognised stock exchange, which records the highest volume of trading in such shares, if the closing price, as on the date closest to the date of vesting of the option and immediately preceding such date, is recorded on more than one recognized stock exchange.
Valuation Scheme for Unlisted Companies
In case on the date of vesting of option, shares are not listed on a recognised stock exchange, fair market value shall be such value as determined by a merchant banker on the specified date.
Changing Trends
Prior to 2009 taxation of sweat equity fell within the ambit of fringe benefit taxation. India Inc. and tax practitioners avenged at the taxation scheme for it being unscientific. The very idea of employer paying the tax on a benefit clearly identifiable and accruing to the employee came as a short in the arm for the critics. As the value of the benefit had to be computed in relation to a future valuation of the share, which would be determined by the market forces as against the controlled valuation of the employer, the prognosis of the critics got strengthened. Further, the FBT paid by the employer was not a tax deductible expense leading to a much higher post-tax expenditure. As a natural corollary, The Finance Bill, 2009 abolished taxation of sweat equity under FBT. Further, taxation of sweat equity was subject to perquisites. Whereby, the burden of sweat equity taxation shifted to the employees' shoulder. Under this scheme the sweat equity is taxed in the hands of employees on the date of exercise. The benefit would be computed as the difference between the Fair Market Value (FMV) of the shares on the date of exercising the options and the exercise price. Further, for the purpose of computing capital gains, fair market value on date of exercise will form the cost basis.
5.2 Japan
In Japan, tax treatment of sweat equity is unpredictable. The Japanese National Tax Agency has challenged the sweat equity practice as a gift in which case entrepreneurs would be required to pay gift tax. Such unpredictability in itself has distorted the incentive of entrepreneurs and venture capitalists to exploit sweat equity scheme. The risk of tax avoidance in connection with sweat equity has thrown up unconventional challenges. It would not be an exaggeration for the Japanese National Tax Agency to view suspiciously the sweat equity practices, owing to its novelty in Japan, which largely stems from the fear of tax evasion. In case, sweat equity were to be allotted in family companies or closely held companies it becomes a path for retiring founders to transfer firm value to their successor-children. Therefore, the conspicuous suspicion of The Japanese Tax Agency is well founded.
The authors are of the opinion that the stand of the Japanese National Tax Agency which has been generalised defies the logic. This (generalist) protracted approach of Japanese National Tax Agency fails to recognise instances where successful invoking of sweat equity provision by the entrepreneur and the venture capitalist in the star-up ventures. In the backcloth of a convenient scheme to distinguish these two above incised different-transactions, the tax agency can deny the pretended sweat equity ex post. Prohibiting sweat equity in general ex ante would impose excessively heavy cost on the Japanese economy. The point blank distinction between gift and sweat equity defeats the hoarse cry of tax evasion by the Japanese National Tax agency. The bright line of distinction separating gift from sweat equity is the desideratum of the latter to recognise and acknowledge the labour of the employees. Further it must be noted that a gift presupposes absence of consideration, the contrary of which is sine qua non of sweat equity issuance. The compensatory nature of the sweat equity shares refurbishes the fallacy of it being a gift. This in other words, is not independent of underlying consideration.
The salient feature that underlies the competitive conflict is that in allocating equity the parties exchange the financial capital contribution of the venture capitalist for the human-capital contributions of the founder. It must be noted that in United States, however, it would look strange if venture capitalists purchased the same common stock that the entrepreneur had bought only a couple of months before, but at a share price twenty times greater than initial paid by the entrepreneur. It must be noted that the major reasons for such purchases in Silicon Valley for Tax evasion. Venture Capitalists would agree without any inhibitions that the common stock, which entrepreneurs acquired, and the preferred stock, which they acquired, is different stock, so their price difference is reasonable As a result, entrepreneurs and executives of start-up companies can avoid current taxation schemes and enjoy tax postponement and reduced tax rates as capital gain. It has been a well established practice that the IRS will not challenge such a scheme of sweat equity, although the climate looks changing by IRS regulations under IRC Section 409A, which has became effective as of January 1, 2009.
At this juncture it becomes important to look at tax treatment across the world look at sweat equity keenly and differently. For instance, in Germany and Australia, sweat equity is taxed on the grant of the option. In the Netherlands and Switzerland, tax arises on irreversible vesting of the option. In Singapore and France taxation triggers when there is exercise or disposal of the options.
Conclusion
Sweat equity rewards the beneficiaries by giving them incentives in lieu of their contribution towards the development of the company. A method of keeping a company's financial capital structure on the basis of monetary investment and human intellect investment follows the golden mean scheme. Major in formidable hurdles at the international level are posing threat to easier issuance of sweat equity. This must be brought to terms at the earliest. As discussed in connection with modus operandi for recognition of recipients the foremost shortfall is the absence of minimum standards or eligibility prerequisites defined at international level as to who must receive sweat equity. This has resulted in the breach of abuse of procedure by the entrepreneurs. Though issuance of sweat equity to employees is subject to their intellectual, technical and scientific contribution to the organisation but what amount of such contribution must be considered for issuance has triggered confusions. This can be largely ascribed to absence of set standards and tangible precedents. In this regard the Authors strongly urge to identify and set blueprints. Authors are conscious of the fact that defining human intellect is very difficult and can lead to lot of critics saying that it will narrow down the approaches and activity of a human but such thing will be less destructive than just having an abstract meaning of the word 'human intellect'. It is to be noted that issuance of Sweat Equity by Company allows them to recognize and appreciate their service. Further, it enables greater employee stake and interest in the growth of an organization as it encourages the employees to contribute more towards the company in which they feel they have a stake. The authors strongly stand for having a uniform approach in issuing sweat equity as well as the proportion in which it should be issued. The procedural compliance should not be stringent and should meet the purpose. In this regard it is very important to be cognisant that Japan follows a very extreme step to prevent business corporations from issuing sweat equity share. It is seen that tax treatment in different jurisdictions are not friendly for issuance of sweat equity and also vary drastically. As against Japan, In India sweat equity shares are considered as perquisite which makes it taxable in the hands of employees. Sweat equity is considered as gift and hence liable to be taxed as gift tax in Japan. The treatment of Sweat equity in Japan is questions the very fundamentals of sweat equity issuance as they are issued in consideration for human- intellect contribution.
