Intricacies around issuance of sweat equity to promoter directors

Glossary of Terms

Cos Act - Companies Act, 2013

Cos Rules - The Companies (Share Capital and Debentures) Rules, 2014

Valuation Rules - Companies (Registered Valuers and Valuation) Rules, 2017

IT Act - Income Tax Act, 1961

IT Rules - Income Tax Rules, 1962

SEBI - Securities and Exchange Board of India

SEBI (SBEB) Regulations - Securities and Exchange Board of India (Share based employee benefits and sweat equity) Regulations, 2021

SEBI ICDR Regulations - SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018

ESOPs - Employee Stock Options

SARs - Stock Appreciation Rights

DRHP - Draft Red Herring Prospectus

IPO - Initial Public Offering

DPIIT - Department for Promotion of Industry and Internal Trade

IVS - International Valuation Standards

Context and purpose

This article presents a structured perspective on key considerations surrounding the issuance of sweat equity shares to Promoter Directors, distinguishing it from other forms of share-based payments such as ESOPs / SARs. It serves as a practical guide to aid informed decision-making, legal and financial compliance and strategic planning for companies evaluating such issuances. The analysis focuses on four critical dimensions:

• The applicable regulatory framework for listed and unlisted companies;

• Valuation requirements;

• Tax implications for Promoter Directors and

• Accounting treatment.

By addressing these aspects, the article aims to assist stakeholders in navigating the legal, financial, and operational complexities involved in such transactions.

Let’s delve into each of these dimensions in greater detail.

Applicable regulatory framework for listed and unlisted companies

Applicable Regulatory Framework

Cos Act

Under section 2(88) of the Cos Act, sweat equity shares are defined as equity shares issued to directors or employees at a discount or for consideration other than cash, in exchange for their know-how, intellectual property rights, or other value additions.

Section 54 of Cos Act permits companies to issue sweat equity shares of a class already issued, provided that:

• the issuance is authorized by a special resolution passed by the company;

• the resolution specifies the number of shares, current market price, consideration (if any), and the class of directors or employees eligible for issuance and

• if the company is listed, the issuance must comply with SEBI (SBEB) Regulations; if unlisted, it must follow prescribed rules.

Cos Rules (for unlisted companies)

Rule 8 Issue of Sweat Equity Shares

A company, shall not issue sweat equity shares to its directors or employees at a discount or for consideration other than cash, for their providing know-how or making available rights in the nature of intellectual property rights or value additions, by whatever name called, unless the issue is authorised by a special resolution passed by the company in general meeting.

For the above purpose, employee means:

• A permanent employee (working in India or abroad);

• A director (whole-time or otherwise) and

• An employee or director of a subsidiary or holding company (in India or abroad).

Rule 12 Issue of Employee Stock Options

Employee for above Rule means:

• A permanent employee (working in India or abroad);

• A director, whether whole-time or not, excluding an independent director and

• An employee or director of a subsidiary or holding company (in India or abroad).

However, it specifically excludes -

• Promoters or persons belonging to the promoter group.

• Directors holding more than 10% of the outstanding equity shares of the company (directly or indirectly, including through relatives or body corporates).

Further, the above restriction is not applicable for a startup company as defined by DPIIT up to ten years from the date of incorporation or registration.

SEBI (SBEB) Regulations (for listed companies)

Chapter IV Issue of Sweat Equity by a Listed Company

Employee for other chapters of SEBI (SBEB) Regulations is largely same as defined in above stated Rule 12 of Cos Rules. However, for chapter IV which deals with sweat equity, Employee means:

• Employees working in India or abroad and

• Directors, whether whole-time or not.

Extract of amendments approved in 210th meeting of the SEBI Board in June, 2025

In a key move, the SEBI has permitted founders to continue holding and/or exercising share-based benefits such as ESOPs granted to them at least one year prior to the filing of the DRHP, even after they are classified as promoters and the company becomes publicly listed.

Under the earlier regulatory framework, promoters were prohibited from holding or receiving such share-based benefits (other than sweat equity i.e., ESOPs / SARs). If any such benefits were held at the time of DRHP filing, promoters were required to liquidate them prior to the IPO.

Analysis

Based on the foregoing statutory provisions, the following key points emerge:

• There is no express prohibition under the Cos Act, Cos Rules and SEBI (SBEB) Regulations that bars the issuance of sweat equity shares to directors who are also promoters. Accordingly, both listed and unlisted companies may issue sweat equity to promoter-directors, provided that the issuance is duly authorized by a special resolution and complies with applicable legal requirements, including valuation, disclosure and lock-in and procedural norms.

• It is essential, however, to distinguish sweat equity shares from other share-based benefits like ESOPs and SARs, where promoters, promoter group members, and directors holding more than 10% of the equity are expressly excluded under both the Companies Rules and SEBI (SBEB) Regulations.

• Accordingly, Promoter Directors can be issued sweat equity but not ESOPs and SARs. Moreover, Promoters who are neither directors nor employees cannot be issued sweat equity shares as well.

• Further, SEBI has recently eased regulations to allow founders (holding share-based benefits other than sweat equity like ESOPs and SARs) who are reclassified as promoters during the IPO process to continue holding ESOPs post-listing, provided the benefits were granted at least one year before filing the DRHP. Earlier, such founders were considered as deemed promoters and were required to liquidate their ESOPs before listing, as promoters were ineligible to hold such share-based benefits. The revised rule recognizes the founders’ role in long-term value creation and aligns with global norms.

Various valuation requirements

Applicable Legal Framework

Cos Rules (for unlisted companies)

Following sub-rules of Rule 8 prescribes the valuation requirements pursuant to issuance of sweat equity.

• Sub-rule 6: Sweat equity shares must be valued at a fair price determined by a registered valuer, with proper justification for the valuation.

• Sub-rule 7: Intellectual property rights, know-how, or value additions being the basis for sweat equity issuance must be valued by a registered valuer, who must provide a report addressed to the Board of Directors, justifying the valuation.

Additionally, under Rule 8(1) of the Valuation Rules, a registered valuer must comply with valuation standards as notified or modified under Rule 18. Until standards are officially notified, valuations must adhere to: (a) Internationally accepted valuation standards, or (b) Valuation standards adopted by a registered valuers’ organization.

SEBI (SBEB) Regulations & SEBI ICDR Regulations (for listed companies)

Regulation 33 of SEBI (SBEB) Regulations

The price of sweat equity shares must be determined as per the pricing requirements stipulated for a preferential issue to a person other than a qualified institutional buyer as per SEBI ICDR Regulations.

Regulation 34 of SEBI (SBEB) Regulations

For sweat equity issuance for non-cash consideration especially against Know-how, IPR or value addition following provisions apply

• The valuation of the know-how or intellectual property rights or value addition shall be carried out by a merchant banker.

• The merchant banker may consult such experts and valuers, as it may deem fit, having regard to the nature of the industry and the nature of the valuation of know-how or intellectual property rights or value addition.

The merchant banker shall obtain a certificate from an independent chartered accountant certifying that the valuation of the know-how or intellectual property rights or value addition is in accordance with the relevant accounting standards.

Regulation 164 of the SEBI ICDR Regulations

For pricing of frequently traded shares, the minimum price (floor price) of equity shares must be the higher of:

• 90 trading days volume-weighted average price on the recognized stock exchange preceding the relevant date, or

• 10 trading days volume-weighted average price on the recognized stock exchange preceding the relevant date.

This is further subject to provisions of Regulation 166A where the issuance leads to change in control or allotment of more than 5% of the post issue fully diluted share capital.

Regulation 165 of the SEBI ICDR Regulations

In case shares are not frequently traded, the price determination must consider valuation parameters such as:

• Book value,

• Comparable trading multiples and

• Other customary valuation practices.

Analysis

Based on the above mentioned relevant provisions, we opine following:

• Valuation of sweat equity shares must align with the applicable regulatory framework and professional standards. For unlisted companies, both the shares and any IPR, know-how, or value addition must be valued by a Registered Valuer in compliance with IVS or those issued by Registered Valuers Organizations (e.g., ICAIRVO), with proper rationale and documentation.

• For listed companies, pricing must follow SEBI ICDR norms based on trading frequency, while valuation of non-cash consideration must be done by a Merchant Banker, supported by expert consultation and certification from an independent Chartered Accountant.

• Importantly, the book value or NAV method alone is not valid under a going concern assumption; instead, fair value must be derived using income or market approaches, as per IVS and commonly accepted valuation principles.

Tax implications for Promoter Directors

Applicable Legal Framework

Section 17(2)(vi) of the IT Act, states that perquisites include

• The value of any specified security or sweat equity shares allotted or transferred, directly or indirectly, by the employer or former employer, free of cost or at a concessional rate to the assessee.

• The value of these securities shall be determined as the fair market value on the date of exercising the option, reduced by the amount actually paid or recovered from the assessee.

• The fair market value must be determined in accordance with prescribed valuation methods.

Rule 3(8) - Valuation of Perquisites

For the purposes of Section 17(2)(vi), the fair market value of sweat equity shares shall be determined as follows:

If the equity shares are listed on a recognized stock exchange on the date of exercising the option:

• The fair market value is the average of the opening price and closing price of the share on that date.

• If listed on multiple exchanges, the fair market value is based on the exchange with the highest volume of trading.

• If there is no trading on the exercise date, the fair market value is determined using the closing price of the nearest preceding trading date.

  If the equity shares are not listed on a recognized stock exchange, the fair market value shall be the value determined by a merchant banker on the specified date.

Section 56(2)(x) of the IT Act

If any person receives, in any previous year, from any person or persons on or after April 1, 2017:

Any property, other than immovable property,

• If received without consideration, and its aggregate fair market value exceeds fifty thousand rupees, the entire fair market value of such property is taxable.

• If received for a consideration lower than its aggregate fair market value by an amount exceeding fifty thousand rupees, the excess value over the paid consideration is taxable.

Shares and securities are included in the definition of "property" under this section. For valuation under Section 56, the FMV of shares and securities shall be determined as per Rule 11UA(1)(c)(b).

Analysis

Based on the above provisions, perquisites clearly include any specified security or sweat equity shares allotted or transferred, directly or indirectly, by the employer or former employer, free of cost or at a concessional rate to the assessee

Thus, Section 56(2)(x) is not applicable, and such shares if given to promoter directors should be taxed as income under the head 'Salary', rather than income from other sources and accordingly valuation as per Rule 3(8) is applicable.

It is our considered view that the FMV, for the purpose of determining the perquisite value in respect of sweat equity shares issued to promoter-directors, is required to be determined by a SEBI-registered Merchant Banker using internationally accepted valuation principles and IVS. It is important to emphasis that the reference to FMV in this context is not linked to book value, nor to any other valuation method prescribed under separate tax provisions (such as Rule 11UA of the IT Rules).

However, if the same are issued to independent director where there is no employer-employee relationship, provisions of section 56(2)(x) will be applicable and accordingly, Rule 11UA will be applicable for determining the FMV.

Accounting Treatment

Applicable Legal Framework

Sub-rule 9 of Rule 8 of Cos Rules (for unlisted companies)

When sweat equity shares are issued for non-cash consideration, based on a valuation report obtained from a registered valuer, such non-cash consideration shall be accounted for as follows:

a) If the non-cash consideration constitutes a depreciable or amortizable asset, it shall be recorded in the Company’s balance sheet, in accordance with the applicable accounting standards.

b) If clause (a) is not applicable, the non-cash consideration shall be expensed as per the relevant accounting standards.

Regulation 35 of SEBI (SBEB) Regulations

Where the sweat equity shares are issued for a non-cash consideration, such non-cash consideration shall be treated in the following manner in the books of account of the company:

a) where the non-cash consideration takes the form of a depreciable or amortizable asset, it shall be carried to the balance sheet of the company in accordance with the relevant accounting standards; or

b) where clause (a) is not applicable, it shall be expensed as provided in the relevant accounting standards.

Para 12 of Ind AS 102 – Share-Based Payment

The para provides that equity instruments such as shares, share options, or other securities are typically granted to employees as part of their remuneration package, alongside cash salary and other benefits and owing to the challenge to directly measure the value of services received for specific remuneration components, the company determines shall determine the fair value of employee services based on the fair value of the equity instruments granted.

Analysis

Considering the above provisions, the fair value of sweat equity shares determined in accordance with IVS by a Registered Valuer should be expensed or capitalized, as applicable, in cases where no monetary consideration is received. Capitalization as an intangible asset is appropriate only if the consideration (such as know-how or IPR) is clearly identifiable, controlled by the company, and satisfies the recognition criteria under Ind AS 38 on Intangible Assets. If sweat equity shares are issued to promoter directors in exchange for expected future services or benefits, the related expense should be amortized over the expected service period, reflecting the period over which the benefits are received. Conversely, if the shares are issued for past services already rendered, the fair value should be charged to the Statement of Profit and Loss immediately, as the obligation has already been fulfilled.