Sweat Equity Agreement: Understanding Startup Equity

When starting a new business or transitioning into a growth phase, balancing your budget with your need for talented resources – and ensuring compliance with employment law – can be a tricky juggling act. Sweat equity can offer a viable solution for those seeking to issue equity without an immediate cash outlay. 

Sweat equity refers to the practice where employees agree to provide work in exchange for an ownership stake in the company. Imagine that, instead of handing over a full payslip each month, you’ve agreed to hand over 10, 100, or 1000 shares. This means your company can hold on to its cash in the present and that your employees become literally invested in seeing the company succeed. Your employee is banking on the company growing, so the shares increase in value, and their hard work becomes even more profitable.

With a sweat equity agreement, your business’s future growth and success will directly benefit your employees. However, there are significant risks associated with offering equity to employees and third parties. To safeguard your company, a sweat equity agreement is non-negotiable.

What is sweat equity?

You may have already heard of sweat equity or the concept. Another way of saying sweat equity is business equity or sweat equity shares. These terms all refer to the same thing.

The central concept of sweat equity is that an employee enters into an agreement to hold an equity share in the company in return for their work. 

Example of sweat equity

Let’s say that Emily is the founder (and shareholder) of a company called The Good Candle Co. She needs a Communications Director, but the company doesn’t have the budget to pay a C-Suite salary. She negotiates with Jake, a seasoned communications professional, to come on board under a sweat equity agreement. Jake agrees, and under the terms of the equity agreement, he holds options (receive equity) in The Good Candle Co. 

If Jake is confident the company will do well in the future, this is a good deal for him, too, as he will increase his amount of equity. His efforts will now be worth even more in the future if the company continues to grow its profits. 

When should I use sweat equity?

It can be challenging to know when sweat equity should be considered, but one thing is certain: a comprehensive, well-written sweat equity agreement is always necessary when you do it.

You may be considering several scenarios:

• How do I structure sweat equity for a co-founder? And how will it work with part-time co-founders?
• Should consultants, advisors, and team members get paid in sweat equity?
• How much equity should I allocate? What’s a fair deal for the type of equity known as sweat equity?
• What kind of milestones and conditions are set for the sweat equity?

Generally speaking, sweat equity is worth consideration in the early days of hiring at a start-up. Once your company is financially able to hire without equity, this is the preferred route. It’s also smart to carefully assess whether you believe someone is a long-term hire before offering equity. While your agreement will certainly cover a situation where the worker leaves the company, this can get relatively complex and sometimes leads to legal disputes. Finally, you should always consider the effect of dilution – giving too much equity away can dilute the primary founders’ control over the business and reduce their financial reward upon achieving an exit.

What you should know about sweat equity?

Pros

• Equity agreements are an effective way to incentivise your early and long-term hires and can be an appealing offer when looking for top-tier talent. 
• Sweat equity helps the start-up maintain its cash flow and keep operating costs low while the business is still in its scaling phase. 
• With an appropriate sweat equity agreement, businesses can manage the risk of offering equity and balance that with their need for growth. 

Cons

• If an employee chooses to leave the company in the middle of an agreement, whether due to another job offer, medical reasons, or relocation, your company may find itself in a difficult position.
• Many sweat equity agreements commonly used don’t work out. A sweat equity arrangement can complicate the management of poor worker performance, especially when termination is required. If your agreement isn’t well-defined, you can find yourself in serious trouble when confronted with poor employee performance and no clear mechanism to recoup the equity offered.
• A poorly written exit agreement can create unnecessary risk for the business, especially when multiple employees with significant ownership stakes choose to leave the company within a short timeframe.
• Sweat equity heightens the risk of tax consequences for both the business and the individuals involved. The equity agreement needs to take this into consideration and mitigate any impacts.
• Offering shares outright can be risky, and setting up alternative equity methods (such as a vesting schedule through an Employee Stock Option Plan, or ESS) is complicated, requiring definite legal assistance.

The downsides to sweat equity can be severe and far-reaching, but that’s not necessarily a reason to discount the idea altogether. When set up correctly and with legal assistance, a sweat equity agreement can be beneficial in specific circumstances. However, this should never be undertaken as a DIY project. The serious legal and financial implications of a poorly written agreement are why it’s always important to engage a professional in the equity process.

What should your sweat equity agreement include?

Your sweat equity agreement should protect the company. Here are a few ways in which a well-written equity agreement can do this.

Give options, not shares

Giving employees options (which only vest at a later date) instead of shares limits the control the worker would have over the company and their rights. Options (until they are exercised) don’t come with voting rights or rights to dividends or liquidation. They’re also easier to cancel if the employee leaves your company, reinforcing the idea that the shares must be earned.

Set clear and measurable vesting KPIs

‘Vesting’ is the process by which a worker ‘earns’ their option, reducing the company’s ability to cancel the option or share. An option can only be exercised (converted into a share) once it has vested. You can use time-based vesting, performance-based vesting (ie, linked to KPIs or milestones), or a combination of the two. 

Include comprehensive and flexible termination and buyback mechanisms

Flexible and comprehensive mechanisms for cancelling or buying back options or shares from workers are essential. You might need to do this if an employee is terminated or resigns, or if your company is preparing for an exit, and you or the buyer wants a clean capitalisation table without a large number of small equity holders to complicate the deal.

Set a Simple Way to Calculate Market Value

A good sweat equity agreement or option plan enables your company to repurchase options or shares from an employee at market value under specific circumstances. It’s essential for the sweat equity agreement to include a straightforward method for valuing company shares. This can be done by the board, through an agreed-upon formula, or by an independent valuer. 

Summary

Offering sweat equity can be an essential tool in the success of a start-up, but it should be done with caution and always in tandem with a clear and binding sweat equity agreement.

Overall, shares should not be given up front. Instead, employees should be offered options with a vesting schedule that includes clear and measurable vesting conditions. KPIs and milestones are important tools when setting up vesting options. Finally, a comprehensive and flexible termination and buyback mechanism is non-negotiable to protect your company. 

The team at UX Law is well-versed in customising sweat equity agreements for start-ups. If you need advice, reach out for a consultation.