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Key Differences between ESOP and Sweat Equity

Key Differences between ESOP and Sweat Equity

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Investment and securities are subject to market risks. Please read all the related documents carefully before investing. The contents of this article are for informational purposes only, and not to be taken as a recommendation to buy or sell securities, mutual funds, or any other financial products.

Although the two terms are often confused with one another, there are many points of difference between ESOP and sweat equity shares. That said, they are fundamentally similar in one key aspect — they’re both methods by which a company can issue its shares to its own employees.

Normally, the shares of a company are listed on stock exchanges following a public issue. But some companies may allocate a portion of their shares to their own employees. This acts as an incentive for the employees and encourages them to contribute to the company’s growth, since that would also lead to a positive effect on their shareholdings.

What is an ESOP?

ESOP is an acronym for Employees Stock Option Plan. As a part of this plan, a company gives its own directors, employees and officers (or to the directors, employees and officers of its subsidiary or holding companies) the option to buy the company’s shares. These shares are issued in exchange for cash as consideration.

If a company plans to offer an ESOP, the classes of employees who are eligible for the plan are predetermined. The price of the shares and the grant date is also specified beforehand. Typically, the price is heavily discounted to motivate employees to invest in the company they work in.

However, ESOPs are not allocated as soon as they are offered. Instead, they are held in a trust fund for a predetermined period, known as the vesting period. In order to be eligible to receive the shares granted to them under an ESOP, eligible employees need to remain with the organisation during the vesting period. If they do, they can exercise their ESOPs and buy the shares of the company at the grant price on the vesting date, which is the date on which the vesting period expires.

What is sweat equity?

Sweat equity is also a kind of equity that is issued to the employees of a company. They are a means for companies to demonstrate their appreciation for certain employees who contribute exceptionally to the growth of the company. In other words, they are a kind of reward for the employees’ hard work and services to the company.

Sweat equity shares are issued for non-cash consideration or at a discount. These shares are allotted to specific employees or directors for any of the following reasons —

  • Exceptional contribution to the successful conclusion of a project or an assignment
  • Exhibition of technical expertise in any given field
  • Value addition by the employee to the company through any outstanding contribution or by rights to intellectual property

Sweat equity shares vs ESOP: The key differences

Now that you know the fundamentals about these two kinds of shares issued to employees, we can take a closer look at ESOPs vs sweat equity shares, and see how they compare against one another in different key areas. Check out the primary differences between ESOP and sweat equity shares in the table below.

ParticularsESOPsSweat equity sharesGoverning sectionSection 2(37) of the Companies Act, 2013Section 2(88) of the Companies Act, 2013MeaningESOPs are options that give the employees of a company the right to purchase the company’s shares at a specified price on a future date.Sweat equity shares are shares issued to the directors/employees of a company at a discount or for non-cash consideration, for contributing to the company in the form of technical expertise or intellectual property. Nature of sharesESOPs are issued as an incentive to retain the top talent in the company.Sweat equity is issued as a reward for employees who have played a significant role in the company’s growth. Eligible recipients

  • Any permanent employee of the company working in India or abroad
  • Any director of the company, including full-time and part-time directors (but excluding independent directors)
  • Any permanent employee or director of a subsidiary company in India or abroad, or of a holding company or an associate company
  • Any permanent employee of the company working in India or abroad
  • Any director of the company
  • Any permanent employee or director of a subsidiary company in India or abroad, or of a holding company

Timing of the issueESOPs can be issued at any time after the company has been incorporated.Sweat equity shares can be issued only after the company has been in business for at least 1 year.Quantum of the issueThere are no restrictions on the quantum of ESOP issue.In case of one-time issues: A company can only issue sweat equity shares up to 15% of its existing paid-up share capital or Rs. 5 crores, whichever is higher. In case of lifetime issues: A company can issue sweat equity shares up to 25% of its paid-up share capital.Consideration for the issueThe consideration for ESOPs needs to be paid in cash.The consideration for sweat equity shares can be paid in cash or as non-cash consideration.Pricing of the issueThe grant price or the exercise price is decided by the company itself. The prices of sweat equity shares are decided by a registered valuer. Lock-in period ESOPs do not have any specific lock-in period. Sweat equity shares have a lock-in period of 3 years.Taxation at the time of allotmentESOPs are considered as perquisites on salary and are taxed accordingly, under the head ‘income from salaries.’Sweat equity shares are taxable under the head ‘income from salaries’ in the year of allotment.Taxation at the time of sale of sharesThe profits from the sale, if any, are taxed as capital gains.The profits from the sale, if any, are taxed as capital gains.

Summing up

The bottom line is that ESOPs and sweat equity shares share some basic commonalities. They are both issued to employees and they may both be at discounted prices. But beyond this, there are many areas of difference between ESOP and sweat equity shares. Knowing these distinctions can help you better understand the kind of shares you receive, if the company you work in issues either ESOPs or sweat equity.

Frequently Asked Questions

1. Why would a company issue an ESOP?

Companies typically issue ESOPs to attract and retain top talent in the recruitment market. ESOPs give eligible employees the option to buy shares in the company at deeply discounted prices. However, they can only exercise their right to buy these shares after a vesting period, during which they need to remain at the company.

This framework gives companies the benefit of retaining talented employees for a longer period. Furthermore, when employees hold shares in the company they work in, it motivates them to contribute further to the betterment of the company.

2. What do you mean by sweat equity?

Sweat equity is a term that refers to shares that are allotted by a company to its employees. They are offered in exchange for the employees’ contribution to the company in the form of technical expertise, value addition or provision of intellectual property rights.

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