Sweat Equity: Will It Ever Walk

Written by YRK Reddy | Updated: Sep 20 2004, 05:30am hrs
Sweat equity is formally in place, with the rules having been issued for unlisted companies also, following the earlier amendments to the Company Law and the SEBI guidelines for listed companies. But it remains lifeless for three reasons. First, many dont seem to make a distinction between stock options and sweat equity; second, there is insufficient understanding of its logic and benefits and lastly, the procedures appear daunting.

Though many do not perceive the difference, sweat equity is not stock options; it is not part of remuneration; and there must be specific and measurable exchange in the form of intellectual property or value addition. Sweat equity is not linked to performance but to the value of the estimated exchange. Unlike stock options, sweat equity is normally a one-time grant and not repetitive. It is mainly intended to lock-in the entrepreneur directors and other critical people not just to attract, retain and motivate employees. Of course, if the company is cash-rich, it can buy the intellectual property and also enter into lucrative contracts to lock-in critical employees for some years.

However, technocrats who initiate a project and work for its success may be inadequately compensated during the initial stages and also may have a relatively small holding in the company. Such a situation may create two types of risks for the company. First is in the case of a technocrat who may have brought in unique technology, which is in his knowledge-domain and continues to be important for the company for some years. If such knowledge cannot be easily substituted from the market, the risk is high for the investors as also for the major creditors. The risk arises out of possible desertion by the entrepreneur as he has little at stake. A lock-in mechanism is required to increase the stake of such a technocrat with the fortunes of the company. In the absence of such lock-in, the technocrat will have at stake, only his earning potential by way of salary and the possible erosion in the value of the stock that he has paid for.

The second risk is the temptation to make money illegally because he deems the salary and dividends as insufficient to compensate the efforts and risks of entrepreneurship and creativity.

Unlike stock options, sweat equity is normally a one-time grant
Companies are operating proxy sweat equity grants to acquire shares
In such situations, the risks for the company increase and the returns to other shareholders diminish. It may lead to managerial excess that is of no value to other shareholders.

The technocrat may rationalise his self-dealing by feeling that all other investors free ride his entrepreneurship. He may reason further, that investment in a company is a mere portfolio-choice for the investors while for him, it is a firm-specific investment with opportunity costs to go along with it.

If the stake is not increased through the sweat equity mechanism, he may find several reasons for creating his own compensation to off-set the free-ride and opportunity cost factors. Regrettably, theres little discussion or understanding of these dynamics. The lack of advocacy has left gaps in understanding as to how sweat equity may mitigate such risks.

The current rules and guidelines are so elaborate that they may meet the ideals of corporate governance and yet are revoltingly cumbersome. They are indeed an over-kill.

The procedures relating to formal valuations, accounting, maintenance of registers, reporting in the prescribed format in the directors report, certificate from auditors/practising company secretary, and taxation are daunting.

For instance, the requirement of a postal ballot, valuations by independent experts/merchant bankers, specific lock-in for three years only, will deter any prospect of a sweat equity culture. Clarity is also awaited on whether sweat equity tantamount to transfer of property.

Several companies are reportedly operating proxy sweat equity grants by innovative ways of gifting or indirectly financing the entrepreneurs and scientists to acquire shares mainly to avoid the high transaction costs of granting sweat equity under the current system.

If sweat equity should meet its objectives, the department of company affairs and SEBI must initiate simplification of rules. They also must undertake advocacy to reduce entrepreneur-related risks including temptations of self-compensating.