LDM | Risk Management

Background

Sweat equity is a hot topic in corporate sector. A company may issue shares to its promoters, employees or directors at a discount or free of cost for their hard work in building the business. So, the company issues shares to those people in consideration of their sweat. This provides a person to gain ownership in a company resulting from work rather than investment of capital. Therefore, people use this concept quite extensively across the world.

Sweat Equity as a Reward

Issuance of equity against the hardship is mainly for rewarding the efforts of the promoters, employees or directors in building the company to the existing level, So, this helps in reflecting the value that they have added. Companies also issue such shares for the value they may add it future. Promoters of the company may put a lot of efforts for is establishment which remains unpaid. Issuance of sweat equity is such a case helps to address the issue.

The work done by the promoters may remain unpaid by the company as the new business may not be in a position to pay wages or salaries during start-up. The commitment by the promoters to provide shares free of cost is often essential for the success of the business. So, this would also allow them to consolidate their control over the company.

Legal Provision in Nepal

Companies may issue sweat equity to the employees or directors of a company for providing know-how or making available rights, in the nature of intellectual property rights. They may issue such shares on a continuous basis as part of their remuneration. This is one of the ways in which a company can provide benefits to its key people. Also it helps to make them owners and keep them motivated. This is similar to an employees’ stock option plan.

Companies Act, 2006 does not have detailed provisions regarding issue of sweat equity by a company. However, clause (a) to the subsection (2) of Section 18 of the Act provides that memorandum of association (MOA) of a public company should mention the provision for issue of shares to the promoters or other persons in consideration other than cash. This provides a room for the issue of sweat equity by a company.

Accounting Issue

One of the reasons for the issue of sweat equity is to reflect in the books of accounts, the value added by the promoters in the company. This would be an interesting issue to the CFOs to account issue of sweat equity.

When a company issues shares, share capital account is credited for the paid-up value of the of shares such issued. This results an increase in the liability side of the balance sheet. To counterbalance this, either asset or expenditure needs to be debited depending upon the nature of non-cash consideration. If the non-cash consideration for issue of sweat equity takes the form of a depreciable or amortizable asset, it shall be carried to the balance sheet of the company. On the other hand, if the non-cash consideration for issue of such shares does not take the form of a depreciable or amortizable asset, it shall be debited in the relevant expense account.

Tax Implications

There may be tax implications on issue of sweat equity. In case of issue of such shares to employees, one may consider the value of shares as perquisites and considered part of their income from salary. On the other hand, for the issuance of such shares to the promoter of the company, determining the cost of acquisition of such shares in the hands of promoters will be interesting. In such a case, one can argue that extending likeness of the cost of bonus shares. Therefore, the cost of sweat equity will be nil.

Conclusion

Sweat equity is one of the effective way for rewarding the promoters or other persons for their valuable contribution in the company. As the company issues it free of cost, everybody related to the company should not claim a stake in the company and asking for their part of cake in sweat equity.