How to Spot the Sweet and the Sour of your Sweat Equity Agreement

Sweat equity can radically help offset financial pressures in early-stage startups, but is everything as sweet as it seems? We take a deeper look at the good, the bad and the sweaty!

1 - What is sweat equity?

Attracting talent when cash flow is low is yet another hurdle founders must tackle on the arduous path of building a successful business. But what if I told you that startups can still attract talent and build a product on a meticulously organised financial model? Well, that’s where sweat equity comes in. It certainly sounds intriguing, but what is sweat equity for startups really about?

A type of cash-free exchange that recognises people for their time, effort, connections and skills, sweat equity is the non-monetary investment startup employees receive through an exchange of their offerings that add value to the project.

For startups, sweat equity is often practiced for early founders or employees who work for a reduced (or altogether absent) salary in exchange for shares in the company. Sweat equity can take the form of employee stock options and even advisory shares. Ultimately, the expectation is that these shares become valuable upon an acquisition, IPO or any other liquidity event.

While having an early stake in a potentially successful company sounds enticing, sweat equity isn’t without its disadvantages. From risk issues to over valuations, we weigh up the pros and cons of sweat equity agreements.

2 - Pros and cons of sweat equity for startups

A powerful and transformative practice for startups, sweat equity can offer attractive solutions for early-stage startups. But it’s not without its drawbacks. Let’s first look at the positives and breakdown how they make for a compelling argument:

• Reduced Spending: By rewarding employees through non-monetary channels, startups can redirect spending towards other essential domains, such as Marketing or Business Development, both critical and costly areas.

• Talent Traction: With inspiring founder success stories becoming more and more common, it’s not surprising many early employees are attracted to equity offers. The attractiveness of ownership stakes rather than immediate monetary compensation certainly works for the wide-eyed entrepreneurs seeking long-term financial success!

• Committed Team: Sweat equity encourages early employees and founders to commit to the long-term vision and enhances their loyalty in the project. This fosters a community of like-minded, equally engaged and motivated team members, who are dedicated to ensuring the company succeeds. Check out our previous article on the importance of a committed and aligned team.

• Increased Valuation: Adding value to a company without incurring extra costs is a win. Work carried out through sweat equity, such as customer acquisition and branding, adds value to the company without necessarily spending a fortune.

From attracting committed individuals to alleviating expenditure, sweat equity makes for a compelling strategy for early-stage startups. But amidst the seemingly positive landscape, sweat equity has a shadowy side – let’s take a deeper look at some of the issues:

• Dilution: Usually, when one party benefits, the other loses out – and that’s no different for sweat equity; giving away shares of the company at an early stage can leave founders with less control and fewer rewards down the line. This is a tricky decision founders or early stage employees have to consider.

• Valuation: Quantifying the value of someone’s effort, time and/or skill, in terms of equity, is tricky business. This leads to difficulty in assessing ownership percentages and potentially leads to disagreements among stakeholders.

• Legal: Tax comes for us all, but when there’s no proper agreement on equity arrangements, legal and taxation issues may arise – and that’s no good for anybody! Additionally, without properly structured agreements (more on that later), sweat equity arrangements can end up in legal disputes with leaving parties claiming portions of the profits that are otherwise not clearly stated.

• Performance: Most entrepreneurs have an innate drive for success - it’s what sets them apart from the rest of us. But when motivation dwindles and performance petters off, it can become increasingly challenging to manage such an individual who has a stake in the company.

• Compensation: Perhaps the most poignant downside of sweat equity is its lack of immediate compensation. It’s all well and good having a share in (what could be a successful) company, but most of us rely on financial remuneration to live and get by. As such, startups that offer sweat equity could be a deterrent for talented individuals who prefer immediate compensation.

• Failure: Essentially, sweat equity is contingent on a company’s success; if the project fails then the equity may be worthless. This is equally poignant if a company undergoes a radical change or is impacted by uncontrollable external forces, causing the company stock to radically decrease in value.

Ultimately, using sweat equity practices to grow a startup has its highs and lows. Navigating this domain requires meticulous planning and its common practice to have signed agreements from all parties to avoid legal, performance and over-dilution issues.

3 - General terms of a sweat equity agreements

As we’ve seen, sweat equity practices can be beneficial to both the individual and the company. But, as we know, things don’t always work out the way we plan – individuals may decide to leave after only a small stint, or there’s a marked shift in the performance of an employee. To ensure such departures are as pain-free as possible, companies often use sweat equity agreements to mitigate any issues.

So, what is a sweat equity agreement? A sweat equity agreement outlines just how much ownership each party earns in exchange for their time and effort. Unsurprisingly, the terms of the agreement will depend on the project, sector and other important factors.

At Angles Partners, not only can startup founders use the platform to make warm introductions to thousands of relevant investors, but they can access a range of resources, including exemplary term sheets and agreements. At Angels Partners, we have built an in-house library of resources to help accelerate the fundraising process and provide founders with the tools they need to confidently tackle the startup journey.  

Although every sweat equity agreements will differ from one company to the next, some general terms include:

1. Parties Involved: Starting with the basics, the names and roles of the individuals and the company involved in the agreement must be clearly stated.

2. Description of Work: Next, a comprehensive list of the tasks, responsibilities and services being provided by the different people should be defined.

3. Amount of Equity: A fundamental part of the agreement, the percentage of ownership or the number of shares each of the individuals owns needs to be given, indicating too if it’s common stock, options or another type. You can read our previous article to better understand how to master equity negotiations

4. Valuation: Calculating the amount of equity given to everyone must be evaluated (and documented) considering different variables, such as hours worked, milestones or revenue contribution.

5. Vesting Schedule: Most companies usually implement a vesting schedule, which protects itself in the case of early departures or poor performances. Common schedules involve 4 years with a 1-year cliff.

6. Deliverables: Along with having clearly defined percentage equities, most agreements contain a clause outlining specific targets or results that an individual must attain to earn equity. These could be referring to hours worked, products launched or client acquisition.

7. Termination: If an individual ceases to work for the company, but holds equity, a termination clause will outline the “next steps”, which can include options, such as buyback rights.

8. Non-compete: To minimise the risk of individuals using company knowledge or intel for competing businesses, confidentiality clauses are usually incorporated into agreements.

9. Disputes: Sometimes, disagreements are inevitable. Incorporating a specific clause that outlines how disputes will be handled (such as arbitration, mediation etc.) is a smart and somewhat necessary clause in any sweat equity agreement.

When it comes to developing and signing a sweat equity agreement, our primary advice: work with a lawyer. Seeking legal counsel is a great way of protecting both the individuals and the business and minimizes future conflict. Additionally, creating a cap table to track equity distribution is a helpful tool to mitigate risks and ensure mutual understanding among parties involved.

One of the common glitches with sweat equity agreements is the potential for disputes, so make sure the terms are as clear as possible – good luck!