In the infant stages, startup companies need to look into several areas like ensuring continuous streaming of funds, making a mark with technological innovation, and retaining human resources. And out of these, employee retention and keeping their motivation levels high is one of the main concerns faced by the employers of the startups.
To work in this area, the employees always try to come up with attractive compensation packages and try to ensure a workforce that is experienced and highly skilled. However, as the startups are illiquid to pay high salaries, they use Employee Stock Option Plan (ESOP) and sweat equity to keep the company running.
ESOP and sweat equity are the most popular methods used by employers to motivate and retain talents. But, though these serve the primary purpose, there are some key differences between ESOP and equity shares.
Delve into the following sections to have a closer look into these methods and their key differences.
What is Employee Stock Option Plan (ESOP)?
ESOP has been provided under subsection 37, Section 2 of the Company Laws.
It is a scheme in which the employees can become shareholders of the company in which they are presently working. The directors or the employer of the startup organization offer ownership rights to the employees and encourage them to buy shares of the organization at a decided price on an upcoming date.
And in this way, the company shows its willingness to share future prosperity with the employee, and as the stocks and shares are marked on a future date, it helps ensure employee retention.
What is Sweat Equity?
Sweat Equity Shares have been provided under sub-section 88, Section 2 of the Indian Companies Act.
In this plan, the shares are issued by organization to employees or the director for non-cash considerations (intangible equity). Or at a discount for providing know-how, offering value-additions in any form of intellectual property.
In this way, the employees who are taking the pay cut in the early stages of the startup are rewarded through ownership percentages or stock options later on.
Key Differences between ESOP and Sweat Equity Shares
Now, let’s have a look into the differences between ESOP and sweat shares.
Nature: ESOPs are more like an incentive that are provided to retain the employees. There is no obligation, and it is like the right of the employee to exercise the option to purchase the stocks or shares.
On the other hand, sweat equity shares are provided to the employee as consideration for offering any value-addition or intellectual property rights.
Allotment: The ESOP scheme is an option for the employee where the employees need to buy the stocks or shares at a decided rate on a future date. These shares are assigned to the director or the employee only after they agree to purchase the shares.
Sweat shares are directly assigned to the employees or the directors for consideration or at discount other than cash.
Eligibility: For an ESOP to be applicable:
- One needs to be a permanent employee of the organization (in or outside India)
- The director of the company (whole-time or part-time) but cannot be an independent director
- A director or a permanent employee of a subsidiary organization (in or outside India) or an associate company.
The following criteria need to be met in the case of sweat share equity:
- A permanent employee of the startup who has worked at least one year (in or outside India)
- The directors of the company (whole-time or part-time).
- A director or an employee or a subsidiary company (in or outside India)
Lock-in Period: It is entirely up to the organization to decide the lock-in period in the case of ESOP.
For sweat equity, the lock-in period is three years, as provided in the Company Rules.
Consideration: For ESOP, the consideration needs to be paid via cash.
In the case of sweat equity, the consideration can be non-cash or at a discount, where it can be partly cash and partly value addition or IPRS.
Restrictions: the company faces no such restrictions when it comes to issuing or granting of ESOPs.
However, in the case of sweat equity, the organization cannot issue more than 15% of the operational equity share in that particular year or stocks (or shares) of the value of Rs. 5 crores, whichever is more.
Also, the sweat equity shares of an organization should not go more than 25% of the equity capital of the organization at any given time.
Pricing Guidelines: It is up to the company to decide the exercise price in ESOP.
On the other hand, a registered valuer decides the pricing guidelines for sweat equity shares.
Tax Implications: Upon the allotment (and after the completion of the vesting period), when the employee decides to exercise his option, the employer should compute the value of the ESOP taxable. It is taxed under the head “Income from salary,” and the employer deducts the tax on such shares.
If the shares are sold within a year (or less than 12 months), it will be considered a short-term capital gain, and the profit accrued will be taxed at a rate of 15%. And if the shares are sold after one year (or more than 12 months), it will be treated as a long-term gain and will be taxed @ 10%.
In the case of sweat equity, the employees will be liable to pay taxes under the head “Salary” in the same year in which the shares are transferred or allotted to the employees.
When it comes to the infant stages of the startup, having a highly-skilled niche workforce can play a significant role in determining its success. And being illiquid to pay high salaries, ESOP and sweat equity remain the best options at hand.
But these schemes are also subject to good execution. And for that, you need to have a clear idea of the key differences between ESOP and sweat equity.
We suggest you skim through the points, and for any assistance, call us!