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.
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.