What is Sweat Equity and How Does it Work?

by Adarsh Raj Bhatt in

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Key Takeaways

  • Sweat equity shares are given to employees and directors of a startup corporation for their efforts toward the startup, commitment to the company, and/or professional understanding of the industry, or employees who have quality experience or have greatly contributed to the startup's intellectual property rights.
  • In exchange for the investors' money, founders, top-level employees, or directors are given the opportunity to share a portion of the profit in the form of "securities." The shares are given away at a discount or for non-cash consideration.
  • Sweat equity shares are primarily used by startups in cases where funding is limited and sweat equity makes a compelling form of compensation
  • Sweat equity shares also prove valuable in big, well-established firms, as these companies have significant funds to invest in the market and receive securities in return. These returns can be shared with the startup's hard-working employees who might be entitled to such incentives in addition to their remuneration.

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What is sweat equity?

Sweat equity is a non-monetary investment made by a startup's founders. It is commonly used by cash-strapped startups and business owners to finance their projects. 

Sweat equity is compensated with sweat equity shares. These are shares issued by a company in exchange for labor and time instead of financial remuneration. Sweat equity shares are essentially discounted shares that a startup issues to its employees and director. An employee or director provides added value in exchange for the shares. 

When founding a startup with limited funding, sweat equity shares are essential. Employees are motivated by sweat equity shares because it creates a more level playing field compared to large corporations. Employees in a startup company established as a corporation might be given equity or stock options, making them part owners of the company in exchange for accepting wages that might be below their respective market value.

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How Does Sweat Equity Work?

Sweat equity shares are equity shares issued at a discount or for consideration other than cash by a company to its employees or directors. In other words, it refers to the distribution of equity shares to employees as a reward for their contributions and hard work (i.e., their "sweat") in delivering intangibles to the business, such as growth or success. 

The issuance of "sweat equity" helps the startup retain and attract top employees by compensating them for their efforts. For example, a business owner with a $30,000 initial investment in their startup wants to sell a stake in it. The business is valued at $1 million, and they intend to sell a 30 percent stake to an angel investor. That leaves them with a $700,000 stake in the company. The sweat equity, which is equal to $670,000, is the value of the business without their cash contribution. 

In such situations, the founders' toil or sweat equity is critical to the startup's survival and might also produce great results when it is ultimately sold to a larger company.

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How to Calculate Sweat Equity? 

Divide the amount of the investor's contribution by the percentage of equity it represents. This fetches you the exact amount of sweat equity that you'll need. 

Let's assume an entrepreneur invests $100,000 in their startup and sells a 25 percent stake to an angel investor for $500,000, valuing the company at $2 million. The increase in the value of their initial investment, from $100,000 to $1.5 million, or $1.4 million (removing the $100K initial investment), is known as "sweat equity."

Here's a good read to understand few more examples of calculating sweat equity.

Benefits of Sweat Equity

1. Saves Money 

Many young businesses are strapped for cash and are searching for ways to cut costs however they can. Offering company equity as a form of compensation will thus help such businesses save money as they expand and become more profitable.

2. Attracts Top Talent and Skills 

Offering equity to valuable employees who you might not be able to afford otherwise will help you attract top talent and skills to your startup. This can be extremely beneficial to a young business in need of specific skills, resources, or quality networks.

3. Creates Incentive 

Since the value of an equity stake increases as a startup's value rises, those who are paid - either in part or in whole - in the form of sweat equity will be even more driven to do their best work to help the company succeed and, by extension, cause their stake’s value to go up as well.

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Limitations of Sweat Equity

1. Difficult to value

Forming a definite consensus about how to value sweat equity can be difficult for a founder. 

Is it just about how much money someone can make in a given position? Is it the additional value that a person's work brings to the company? In the end, the exact worth of sweat equity is determined by the startup - and it’s a tricky thing to value.

2. Can result in disputes 

The uncertainty surrounding the valuation of sweat equity can lead to potential internal conflict. 

For instance, in some cases, employees might believe that their contributions are more valuable than what the employer values them to be. This can cause internal tension, which can have a negative effect on the whole venture.

3. Causes unprecedented delays

Sweat equity, when valued correctly, does a good job of aligning motivations and deliverables, but it might also have unintended negative consequences. 

If you're offering only shares instead of money for the work done, keep in mind that people can’t subsist on shares alone. How do you expect the individual to survive and pay their bills if you only offer shares in return for the work done? If a person does not have enough money in the bank to cover basic expenses, they will be forced to work a second (or third) job in addition to what they are doing for you, limiting the amount of time and headspace that they will devote to your project. 

The same is true if you offer a business sweat equity. If the company does not have enough money to pay its employees, it will be forced to take on other contracts, which will delay the completion of your project (or dilute the quality of work put into it). 

How to Write a Contract with Sweat Equity?

You'll need a straightforward equity agreement written with potential contingencies in mind. 

In general, a sweat equity agreement should have the following provisions:

Maximum equity amount that can be earned 

If you're in a two-person partnership, for example, you might want to limit it to 50 percent. The cap is always set much lower in larger corporations. It's also a good idea to set a minimum amount of equity that could be earned.

Rate at which a company's equity grows 

To measure equity, one fairly reasonable method is to use the person's income or rate of pay. 

For instance, if an individual is paid $30,000 per year, they might be able to finish the year with this much equity instead of a paycheck.

Conversion rates

Will the sweat shares be converted to equity on a monthly basis? 

If the individual is obtaining voting rights, this provision (of conversion rates) could be extremely important.

Period of vesting 

In general, you do not want the individual to start gaining equity right away, particularly if they are new to the startup. 

You could set a vesting period (say, a six-month vesting period) during which the employee would be paid in cash for their work and then eventually begin to earn equity once vesting starts.

Criteria for performance

Be abundantly clear about each partner's obligations - something which is especially important if one partner takes on several roles at the same time.

Compensation Type and Amount 

What type of equity would the employee receive, and how much are you prepared to offer?

Terms of separation

How can this agreement be broken? Who can break it? When an employee leaves the company, what happens to their sweat equity?

Sweat Equity Agreement Template

Sweat equity agreement template
Source

A sweat equity agreement preserves your employees'' right to equity in the business by having them sign a legal document. 

Before you get cracking on your contract, check out some more sweat equity agreement templates and Sweat Equity Partnership Agreement Templates.

What is an Example of Sweat Equity?

Sweat equity can come in a variety of forms. 

Consider a startup that wants to employ an accomplished marketing professional. Such a young company may not have enough funds to attract the industry's best, high-quality resource(s) needed to set it apart from the competition. 

The business has a better chance of bringing in the experienced people that it wants - without breaking the bank - if it provides equity to them as compensation.

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 Citations 

  1. How Much Is Sweat Equity Worth?
  2. Should I Use A Sweat Equity Agreement For My Startup?
  3. Sweat Equity in U.S. Private Business
  4. Sweat equity shares: meaning, merits, taxation