“Sweat Equity”

The meaning of adequate consideration in terms of the Companies Act of 2008

It is a common arrangement, especially in small start-up businesses, for shareholders to receive shares in return for their labour, ideas, business savvy and intellectual property. This is known as “sweat equity” and was an elusive area of company law, until the amendments of the Companies Act 71 of 2008. The questions arising from such arrangements concern the fiduciary duties of directors in issuing shares, the value of the sweat equity at the time the shares were issued, and the complications of a retrospective arrangement.

There are two circumstances where shares might be issued in return for labour and services: with an agreement upfront for the shareholder to render future services to be returned for shareholding, and with the issue of shares after such services have already been rendered.

If shares are issued, especially at a later stage where the new shareholder has been working for the company for some time, in return for services and labour rendered by the new shareholder, directors must take care not to prejudice the interests of existing shareholders and avoid diluting their shareholding. This requires directors to apply their minds to the value of the services rendered compared to the value of shares being issued and communicate with the new shareholder to ensure their labour and services are properly valued. Directors may also be required to value the company before issuing the shares, an exercise which can also be difficult and an independent auditor may need to be engaged for this purpose.

The board will need to determine what adequate consideration for the shares to be issued will be, whilst balancing their duties to act in good faith, for proper purpose, in the best interests of the company – and uphold their duty to do so with due care, skill and diligence. Directors’ failure to act in accordance with their fiduciary duties, the breach of these duties, may result in a director being held personally liable in terms of S77(2) of the Companies Act for any loss, damage or costs incurred by the company as a result of their breach.

Circumstances of sweat equity are governed by s40 of the Companies Act, and particularly by s40(5) & (6). These sections provide that the board may issue shares in return for adequate consideration but, where the consideration is in the form of future services, future benefits or future payment by the subscribing party, then the shares must be held in trust and subject to a trust agreement between the parties and a 3^rd party holding the shares in trust.

S40(5) says that:

(5) If the consideration for any shares that are issued or to be issued is in the form of an instrument that is not negotiable by the company at the time the shares are to be issued, or is in the form of an agreement for future services, future benefits or future payment by the subscribing party—

(a) the consideration for those shares is regarded as having been received by the company at any time only to the extent—

(i) that the instrument is negotiable by the company; or

(ii) that the subscribing party to the agreement has fulfilled its obligations in terms of the agreement; and

(b) upon receiving the instrument or entering into the agreement, the company must—

(i) issue the shares immediately; and

(ii) cause the issued shares to be transferred to a third party, to be held in trust and later transferred to the subscribing party in accordance with a trust agreement

The mechanism described above operates as follows: the subscribing shareholder must enter into an agreement with the company as to the number of shares they are to receive, the services they are to provide, and the time frame for performance. This agreement should be incorporated into a trust deed including the specifics of the trustee’s powers and vesting date – which presumably shall be on the date of fulfilment of the shareholder’s obligations.

This mechanism contrasts with the 1973 Companies Act which required a subscription price to be paid in full before the issue of the shares. The mechanism for subscription of shares prior to payment of consideration provided for in the 2008 Act is useful in catering of circumstances of sweat equity, particularly as an alternative financing arrangement for empowerment investors.

Conditions of vesting of the shares are dealt with in s40(6) of the Act:

(6) Except to the extent that a trust agreement contemplated in subsection (5)(b) provides otherwise—

(a) voting rights, and appraisal rights set out in section 164, associated with shares that have been issued but are held in trust may not be exercised;

(b) any pre-emptive rights associated with shares that have been issued but are held in trust may be exercised only to the extent that ………..or the subscribing party has fulfilled its obligations under the agreement;

(c) any distribution with respect to shares that have been issued but are held in trust—

(i) must be paid or credited by the company to the subscribing party to the extent that ………..or the subscribing party has fulfilled its obligations under the agreement; and

(ii) may be credited against the remaining value at that time of any services still to be performed by the subscribing party, any future payment remaining due, or the benefits still to be received by the company; and

(d) shares that have been issued but are held in trust—

(i) may not be transferred by or at the direction of the subscribing party unless the company has expressly consented to the transfer in advance;

(ii) may be transferred to the subscribing party on a quarterly basis, to the extent that ………..or the subscribing party has fulfilled its obligations under the agreement;

(iii) must be transferred to the subscribing party ………..upon satisfaction of all of the subscribing party’s obligations in terms of the agreement; and

(iv) to the extent that ………..the subscribing party has failed to fulfil its obligations under the agreement, must be returned to the company and cancelled, on demand by the company.

In a nutshell, the shares held in trust are subject to the parties’ agreement. Voting rights will not be exercisable unless this agreement provides otherwise. Pre-emptive rights are exercisable to the extent that the agreement has been fulfilled by the shareholder, i.e. the proportion to which they have rendered their services. The same principle applies to distributions, which may also be credited against the shareholder’s remaining “debt” – the value of the services they are still to render. Such distributions will also be in proportion to the accrued shareholding proportionally to services already rendered. Shares held in trust may be transferred as they accrue to the shareholder. Shares will not accrue if the shareholder fails their obligations in terms of the agreement and will not vest with the shareholder but may be returned to the company.

The agreement should clearly state the amount of shares to be issued to the shareholder, particulars of the services and labour the shareholder should provide, and the monetary value of the shares at the time of the agreement. The agreement should specify how the shares will accrue to the shareholder and when they may be released from the trust. Without assigning a value to the shares and using this to assign a value to the services rendered, directors may be at risk of accusations that they are breaching their fiduciary duties. Clarity on these points assists with transparency and secures the prospective shareholder and the directors against future disputes regarding the agreement. Note that should the agreement be designed to provide financial assistance to the subscribing shareholder then the provisions of s44 of the Act must be taken into account and such assistance may require a special resolution of the shareholders.

A more complex problem might arise if an employee is offered shares as a bonus after years of service. The Act makes specific provision for prospective labour and services provided by the shareholder as “sweat equity” but does not make provision for the award of shares for retrospectively – for services already rendered. In this scenario the correct view to take is that the employee has already been remunerated for work performed in the course and scope of their employment if paid a salary and to separate this work from the transfer of shares. If the employee has made additional contributions to the company, or “sweat” that goes beyond their employment, then the contributions will need to be valued and shares assigned based on that value. Again, this a more complex issue as it is retrospective – the contribution has already been made and disputes may arise on how to value them and what proportion shareholding they are worth. Naturally, a simple way to avoid any dispute of additional contributions beyond the course and scope of an employee’s normal employment is to insert a clause in their contract governing this – usually in the form that all intellectual property developed by the employee during their employment belongs to the company.