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How are other startups dealing with non-employee sweat equity vesting ?

hi guys,

under the new companies act, giving out of stock options to non-employees is forbidden. So I’m curious to know how are other startups dealing with a simple thing like stock options to other people (advisors, consultants , etc.) without having them onboard as an employee.

Do note that I’m aware that stocks can be granted by a founder to people – but it is not as clean as a nice vesting schedule, etc. Is this the only way to deal with giving stock to non-employees now ?

do note that I’m asking about India-incorporated startups… if you were smart and incorporated in Singapore/US, then life is much easier for you 🙁

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  1. Almost a decade after the Companies Act, 1956, was amended to allow companies to issue sweat equity to employees and directors, there have been few takers for the instrument, at least among listed companies.

    While there’s no formula or one-size-fits-all approach, there are a number of factors that are generally taken into consideration:  This also depends on the agreements in place with you the shareholders and employees in this regards

    Sweat equity is essential when a company is formed, to assure the financial investor that the knowhow providers would stay on, or for a start-up with limited resources to attract highly-qualified professionals to join the team as long-term stakeholders.

    Sweat equity shares

    It is not common for sweat equity shares to be issued with restrictions, except those of a general nature such as on transferability. However, sweat equity shares must be locked in for three years from the date of allotment (SEBI (Issue of Sweat Equity) Regulations 2002 and the Unlisted Companies (Issue of Sweat Equity Shares) Rules 2003).

    One of the Reasons, News which made Sweat Equity DO THE ROUNDS IPL: 10% sweat equity kept for neta, cricket honcho

    What is sweat equity?

    Sweat equity refers to shares given to a company’s employees or directors on favourable terms in recognition of their work. These shares are issued to employees or directors at a discount or for a consideration other than cash for providing know-how, making available rights in the nature of intellectual property rights or value additions.

    Why is sweat equity issued?

    The idea behind issuing sweat equity is to retain your best employees. There is no limit to the discount on share price that can be offered. Sweat equity makes employees part owners of the company and gives them a share of profits earned.

    Is there any limit to the amount of sweat equity?

    The sweat equity issued during a year should not exceed 15% of the total paid-up capital of the company or a value of Rs 5 crore, whichever is higher. The company needs to get prior approval of the central government to go beyond this level. It is also restricted from issuing sweat equity before completing one year of incorporation.

    Who determines the value of sweat equity?

    The price of sweat equity shall be determined by an independent valuer. If shares are issued for a consideration other than cash, the valuation of intellectual property or know-how shall be carried out by a valuer. Such valuer shall consult experts considering the nature of the industry and the value addition.

    What steps do a company need to take?

    The issue of sweat equity shares should be approved by shareholders by means of a special resolution at a general meeting or an extra-ordinary general meeting of a company. The explanatory statement accompanying the notice of the general meeting should include reasons and justifications for such the sweat equity issue, value of such shares, the valuation report and other details.

    Sweat equity shares are no different from employee stock options with a one year vesting period. It is essential when a company is formed, to assure the financial investors that the knowhow providers will stay on, or for a start-up with limited resources to attract highly-qualified professionals to join the team as long-term stakeholders.

    These shares are given to a company’s employees on favourable terms, in recognition of their work. Sweat equity usually takes the form of giving options to employees to buy shares of the company, so they become part owners and participate in the profits, apart from earning salary.

    Section 79A of the Companies Act lays down conditions for the issue of sweat equity shares. For listed companies, there are regulations made by the SEBI. The SEBI also prescribes the accounting treatment of sweat equity shares. Thus, sweat equity is expensed, unless issued in consideration of a depreciable asset, in which case it is carried to the balance sheet.

    Sweat equity is a device that companies use to retain their best talent. Usually, it is given as part of a remuneration package. However, start-ups sometimes use sweat equity to retain talent. If the company fails, its employees may end up with worthless paper in the form of sweat equity shares.

    Employee share plans in India: regulatory overview

    Sweat equity shares

    Discretionary/all-employee. Sweat equity shares can be offered to employees or directors on a discretionary basis, by both public and private companies. A shareholder resolution must specify the class or classes of directors or employees to whom sweat equity shares are to be issued (Companies Act, 2013).

    Non-employee participation. Sweat equity shares can only be issued to employees and directors.

    Maximum value of shares. Unlisted companies require prior government approval to issue sweat equity shares for more than the higher of either (Unlisted Companies (Issue of Sweat Equity Shares) Rules 2003):

    • 15% of the total paid-up equity share capital in a year.

    • Shares with a value totalling INR 50 million or more.

    In addition, sweat equity shares form a part of managerial remuneration and therefore the allotment of sweat equity shares must comply with the managerial remuneration ceilings under the Companies Act, 2013.

    Payment of shares and price. Payment for sweat equity shares can be in the form of cash consideration or other consideration, for example, intellectual property rights, know-how or some other item of value. For listed companies, under the SEBI (Issue of Sweat Equity) Regulations 2002, the pricing of sweat equity shares cannot be less than the higher of the following:

    • The average of the weekly high and low of the closing prices of the related equity shares in the six months preceding the relevant date (which is 30 days before the date of the shareholders’ meeting).

    • The average of the weekly high and low of the closing prices of the related equity shares during the two weeks preceding the relevant date.

    If sweat equity shares are issued for non-cash consideration, valuation must be carried out by a merchant banker.

    Are there any corporate governance guidelines, market rules or other guidelines that apply to any of the above plans?

    Institutional investor guidelines.

    Besides the general corporate and tax laws, the specific laws governing ESOPs, ESPPs, sweat equity shares and other similar plans are as follows:

    • SEBI ESOP Guidelines (applicable to listed companies and companies that are proposing to list).

    • Unlisted Public Companies (Preferential Allotment) Rules 2003 (applicable to unlisted public companies).

    • SEBI (Issue of Sweat Equity) Regulations 2002 (applicable to listed companies).

    • Unlisted Companies (Issue of Sweat Equity Shares) Rules 2003 (applicable to unlisted public companies).

    • Foreign Exchange Management (Transfer or issue of security by a person resident outside India) Regulations 2000 (applicable when an Indian company issues options or shares to employees outside India).

    • Foreign Exchange Management (Transfer or Issue of Any Foreign Security) Regulations 2004 (applicable when a foreign company issues options/shares to an Indian employee).

    What Every Founder Needs to Know About Equity

    Capital Contributions: One co-founder may be in a position to make a significant capital contribution to the company, and you might think she could just get additional founder shares in return. But, it’s typically better to allocate founder equity based upon each person’s actual level of work contribution (called “sweat equity”) and treat financial contributions from a founder the same way you would that of a seed investor—by issuing convertible debt or series seed preferred stock.

    A Good Debate and Read here on the topic and more

    How others are doing it could be sampled here as well

    Here is a Vesting Calculator

    Good Advice… is Priceless!!!
    Not what you Want to hear, but what you Need to hear.
    Not imaginary, but Practical. Not based on fear, but on Possibility.
    Not designed to make you Feel better, designed to make you Better.
    Seek it out and embrace the true friends that care enough to risk sharing it.
    I’m not sure what takes more Guts — Giving it or Getting it. Seth Godin~

    Choose what options work for you!! Would leave the finer details for the Legal Eagles, this is only as per my own understanding and research on the Topic !

    Cheers!!

  2. hi Darshan, thanks for the extensive reply. Unfortunately, this is unusable because the new companies act makes a lot of the aspects unviable. Some people have advised us to develop a new SHA for a vesting schedule based founder transfer of shares. But seems kind of messy.

  3. Write out simple contracts of consultation with them  and reward them with ESOPS.

    It gets harder when you have to deal with Non Resident, Non Indian partners, but there are solutions.

    You could also mail my CFO – Satish@c2wgroup.com and request help (mention me)

  4. @alok – thank you very much for your answer ! really appreciate it.

    This is the first time I have been told that ESOPs can be awarded for contracts of consultation – I have many questions around how vesting would work, etc. Is it possible to ask you (or Satish) for a sample contract ? That would indeed be very, very helpful.

    We have multiple lawyers tell us multiple things, but not a single practical/applicable solution which has actually been put in practice.

    regards and thanks

    -Sandeep

    • Hi Sandeep, Did you get an appropriate solution for this problem. I too am facing the same issue. Indian start up needing to issue sweat equity to a consultant.You had also mentioned “stocks can be granted by a founder to people . Can you elaborate more on the same

      • Hi Madura,
        Am facing a similar issue. Need to issue stock options to an advisor & just got to know it’s not allowed. Were you able to work around this problem? Pls let me know your email/number so we can connect directly. Am at pooja@thenewu.in
        Thanks!

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