Employee Retention Strategies – Are ESOPs different from Sweat Equity?

Amongst start-ups particularly the question of employee retention and reward (for working with a start-up) is asked very frequently. This blog post seeks to identify and discuss the legal parameters surrounding both mechanisms arming promoters with answering the question of whether ESOP or Sweat Equity.

What is an ESOP?

An ESOP is a type of employee benefit plan which is intended to encourage employees to acquire stocks or ownership in the company. Under an ESOP, the employer grants stocks of the company to the employee at a discounted price, these stocks remain in the ESOP trust fund, until the vesting of the options and their subsequent exercise by the employee. ESOPs can also be used effectively for obtaining financing at a time when required by the company.

What is Sweat Equity?

Sweat equity shares mean such equity shares as are 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 other value additions. This is an effective tool to reward and provide incentives to the employees for commendable performances. It also, provides employees with an objective to contribute more effectively towards the company’s development.

Issuance

Sweat Equity Shares are issued as consideration other than cash for Value Additions. These can be issued to employees, officers and directors of the company.

Value Additions” means actual or anticipated economic benefits derived or to be derived by the company from an expert or a professional for providing know-how or making available rights in the nature of intellectual property rights, by such person to whom sweat equity is being issued for which the consideration is not paid or included in the normal remuneration payable under the contract of employment, in the case of an employee.

Whereas ESOPs are given in the nature of an incentive and retention plan, these can be issued to employees and officers. ESOPs cannot be issued to Promoter or person belonging to the promoter group. The issuance is of a grant / option to the employee that will vest into an exercisable right at a future point in time.

Entitlement of Sweat Equity and ESOPs

Certain classes of persons are excluded from the purview of ESOPs such as independent directors and promoters of the Company. However, sweat equity may be issued to a director regardless of him being a whole time director or otherwise. The definition does not include specifically, an independent director. Such employee should have completed one year in the organization.

Lock-in period

A mandatory three year lock-in is prescribed for sweat equity shares, however, the board has been given the discretion to prescribe a lock-in for ESOP shares.

Limitations

The issuance of sweat equity shall not exceed 15% of the existing paid up equity share capital in a year or shares of the issue value of INR 5 crore, but it shall not exceed 25%, of the paid up equity capital of the company at any time. No such restriction has been prescribed for ESOPs.

Timing

Sweat Equity shares cannot be issued prior to the expiry of one year from the date of commencement of business by the Company. No such restriction has been prescribed for ESOPs.

Pricing

Sweat equity shares prior to issue shall be valued at a price determined by a registered valuer as the fair price. The valuation of Value Additions for which sweat equity shares are to be issued, shall be carried out by a registered valuer, who shall provide a proper report addressed to the board of directors with justification for such valuation. The Board is free to determine the exercise price or the formula for such exercise as per the existing accounting policies of the company.

Transferability

No restriction on transferability of Shares after completion of lock-in period. The board may impose a lock-in for issued pursuant to exercise of an ESOP. However options granted to employees shall be non-transferable and shall not be hypothecated, pledged, mortgaged or otherwise encumbered or alienated in any other manner.

Start-ups should, while determining which employee retention strategy to be used, consider all of the above, Promoters may also consider sweat equity to protect them from dilution of their shareholding at the time of any investment by seed / VC investors.

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