Sweat Equity Share

Sweat equity is the value added to an entity as a result of one’s work. No financial capital is paid in to add value. It can also be understood as the value of human capital one puts in his business. Sweat equity is a good tool for attracting skilled manpower to your company and retaining them for a long term. As the skilled employee works with an organisation, he keeps on adding value to it and hence increasing his sweat equity too. Sweat equity is also relevant in a non-business scenario. When someone is repairing his house or his car, he is increasing their value by putting in an effort.

In the case of organizations issuing sweat equity, the equity or shares can be issued without any financial consideration or at a discount.

Sweat Equity Example

Suppose an entrepreneur starts his company with an initial capital of USD 10,000. He works in the business for 5 years and eventually sells it off for USD 1,000,000. The value generated by the entrepreneur is USD 990,000 which is due to the work that he put in the business. The value of sweat equity, in this case, is USD 990,000.

Another example can be when a company hires an employee with a certain skill set. The company will give him equity ownership in the business without any financial consideration in the form of sweat equity. The value of sweat equity in such a case can be estimated by measuring the value added by the skill set of that employee.

Sweat Equity Share and ESOP

Companies also give ESOPs for hiring and retaining talent, especially in start-ups. An ESOP is essentially a call option to buy the company’s share at a pre-determined price when the valuation has increased in the future. ESOPs usually come with a vesting schedule where the full award vests in tranches over a long period of time (usually 4-5 years). Once ESOPs are vested to the employee, he has to exercise them in a certain period to reap the benefits. Failing so, the options lapse and are worthless.

Sweat equity is different from ESOP. As opposed to being a call option, sweat equity shares are actual shares which get vested to the employee directly. In the case of ESOP, the employee has to first exercise the option to get the share. ESOP has value if the current price of the share is more than the exercise price of the option. A sweat equity share always has a certain value except when the company goes bankrupt. Companies are usually more liberal in giving ESOP than sweat equity. It’s because ESOPs lapse if the employee leaves the organisation before a stipulated period. But sweat equity once paid can’t lapse. It’s a part ownership of the business and will stay forever unless the employee decided to sell his sweat equity share. The financial exposure to the company is more in cases of sweat equity.

Sweat Equity Taxability

Sweat equity is a form of income. So, it is taxable as income when it is awarded for the first time. There is no capital gain associated with the sweat equity when it is first awarded. But when it is sold later at a higher value, there might be a capital gains tax associated with it. If the founders are awarding themselves sweat equity, they can avoid the tax by awarding it before the company incorporation. Once the company is incorporated, any sweat equity award is taxable as normal income.

Sweat Equity Accounting Treatment

Sweat equity is paid for the skills and work that an employee has put in. It is essentially an expense. If the company maintains expense accounts, sweat equity can be debited from that. Else, it can be debited from cash. On the equity side, the company will need to increase the issued capital by the same amount. The common stock will need to be credited with the par value of sweat equity shares and paid-in capital with the difference between current value and par value of sweat equity shares.

References:

 Articles:

Last updated on : January 6th, 2018
What’s your view on this? Share it in comments below.

Leave a Reply

SWOT Analysis
  • Wealth Maximization
    Wealth Maximization
  • Intellectual Property Rights
    Intellectual Property Rights
  • Profit Maximization vs. Wealth Maximization
    Profit vs. Wealth Maximization
  • Financial Modelling
    Financial Modeling
  • Subscribe to Blog via Email

    Enter your email address to subscribe to this blog and receive notifications of new posts by email.

    Recent Posts

    Find us on Facebook


    Related pages


    costdriversbenefits of convertible bondsfixed asset turnover interpretationfuture value and present value formulasasset turnover explainedstock turnover period formulafeatures of capital budgeting decisionconglomerate integration examplesdebt equity ratio formula with exampledepreciation and amortization formulainitial outlay calculatorhow is roce calculatedoverdraft facility feeinventory turnover ratio calculation exampletypes bill of ladingr&d ifrs vs gaappreferential shares vs ordinary sharesdays in receivables formularecording capital leasesg&a calculationdsc loanhow to account for capital leasesadvantages and disadvantages of discounted payback periodcalculate constant growth ratedebit credit analysis exampledouble entry system of bookkeepingbond tenorearnings per share formula accountingplain vanilla bondnon redeemable debentureshybrid financing definitiondefinition of preference sharesshogun bonddebenture rateirr explanationdifference between current and noncurrent assetsdefine fixed asset turnoverwhat is the difference between hire purchase and leasingdefinition of paybackcurrent liquidity ratio formuladebits and creditratio analysis in financial accountingadvantages of payback period methodnon recourse factoringcalculate benefit cost ratiowacc componentsdividend per share formuladebtor turnover daysdefinition of debits and creditsgolden growth modelearnings capitalization modeltypes of financial guaranteesmulti stage dividend discount modelwacc projectdefinition of rationing in economicsreasons for increase in gross profit marginhow to calculate internal rate of returninvoice finance definitionsemi variable costs definitionhow to calculate operating cyclethe asset turnover ratio is computed by dividingtrade off theory in capital structurefactor models and arbitrage pricing theorym&m taxesreturn on shareholders fund formularecievable turnover ratioaccounts receivable turnover in days formulaweighted cost of capital calculatorcapitalized lease definitiondiscounting definebalance sheet disadvantagesbank overdraft interest ratehigher purchase loanmerger and acquisition advantages