What is Sweat Equity?

Typically, promoters of a company dedicate time and effort to the growth of a company. It is only fair for promoters, founders, or key employees to be rewarded for resolute perseverance. In addition to value creation and monetary benefits, sweat equity is considered a form of compensation.

What is Sweat Equity?

sweat equity refers to the non-cash contribution of a person to a business venture or project. It commensurates the physical efforts, mental labour, and time dedicated to value creation. It is important to note that sweat equity and equity capital are distinctly different. Equity capital is the financial commitment of the shareholders whereas sweat equity is the efforts involved with developing a business or a particular activity.

The meaning of sweat equity can be explained with the following example:

An e-retail venture values the efforts involved in its development at INR 40 Lakhs. A venture capitalist is interested in investing INR 50 Lakhs in the business in return for a 20% stake in the venture. Thus, the valuation of the company can be estimated at Rs. 250 Lakhs.

The promoter(s) is entitled to an 80% stake which may be valued at 200 Lakhs which includes INR 40 Lakhs of initial investment and a benefit of INR 160 Lakhs. The benefit of 160 Lakhs is termed sweat equity.

What are sweat equity shares?

Sweat equity shares are an extension of the above concept. It refers to shares offered to key employees or directors of a company at a discounted rate. Sweat equity shares are issued instead of the efforts and time dedicated by employees to the company.

Sweat equity shares also include stock options offered to employees. In the early stages of a company, employees may be offered stock options to compensate for below-market-rate salaries. Often, cash-trapped companies with growth potential offer stock options to employees.

Similarly, in a partnership firm, the initial partner may get sweat equity in the firm and require the subsequent partners to pay the financial capital. In this case, the time and efforts involved in developing the business contribute to sweat equity.

The primary purpose of sweat equity shares is to offer a share in the ownership of a company with exponential growth potential. In effect, compensation of the sweat equity shareholder is linked to the growth trajectory of the company.

The calculation of sweat equity is a function of the valuation of a company in conjunction with the time and efforts involved in the development of a company.

How does Sweat Equity work?

For example, the founder of a fintech startup may value the efforts involved in developing a platform and charting out a business plan at INR 20 Lakhs. The employees of the company may value the time taken for business development and the establishment of systems at INR 5 Lakhs. In this case, the valuation is INR 25 Lakhs. However, the actual value may be more or less.

Let’s suppose an investor purchases a 20% stake for INR 20 Lakhs which signifies a valuation of INR 100 Lakhs. The balance 80% stake is valued at INR 80 Lakhs. Excluding the initial cost of INR 25 Lakhs, the company has a non-monetary benefit of INR 55 Lakhs from the transaction.

Further, let’s suppose the company has issued 100,000 shares at INR 25 Lakhs. The value per share is INR 25 through which the employees can be compensated in the form of sweat equity shares for their initial efforts. Employees who performed sweat equity work worth INR 5 Lakhs must be offered 20,000 sweat equity shares as compensation.

What is the importance of sweat equity shares?

Sweat equity shares are issued in multiple scenarios, each serving a different purpose.

• Employee Retention: To retain talent, companies offer sweat equity shares to their employees with a retention period. Employees are eligible to purchase such shares only on completion of a specified number of years with the company.
• Raise Capital: Sweat equity is an efficient method to raise capital without affecting the outstanding debt of the company. Excessive debt can have an impact on the financial health of the company.
• Boosts Performance: Sweat equity shares are also offered in exchange for accomplishing certain parameters. Parameters may include a specified level of return on equity or earning per share over a multi-year time frame.

In conclusion, sweat equity enhances the valuation of a company irrespective of the initial monetary contribution. Parallelly, it increases the stake of an individual in the ownership of a company leading to a personal interest in the performance of the company. Sweat equity shares can benefit the company in multiple instances based on the business requirement.