In the startup world, sweat equity is an ownership stake that is used as compensation to those making non-monetary contributions to a business. If a new company does not have sufficient cash assets to pay partners, employees, or other experts needed to get their business off the ground, they may issue equity in the company in lieu of some or all monetary compensation. Sweat equity can be used to pay for labor, expertise, networking connections, credibility, or other important contributions to a business.
Sweat equity can take many forms. Take, for example, a start-up looking to bring on an experienced marketing professional. As a young company, it likely does not have sufficient capital to attract the quality work needed to make the business stand out from the crowd. By offering equity in the company as compensation, the business has a better chance of bringing on the help it needs without breaking the bank.
The value of sweat equity is fairly subjective and can be calculated in a number of ways. It could be the amount in wages that an employee would make working elsewhere, the amount you would have to pay to hire someone else, the estimated increase in value that the employee’s work has added to the company, or a combination of these factors. Ultimately, each company will need to establish and stick with a valuation standard for any sweat equity they offer.
If your LLC plans to offer sweat equity, it is critical to address this and all associated issues in your operating agreement. Because LLCs allow for a great deal of flexibility in terms of voting rights, ownership stakes, and profit distributions, you will need to decide ahead of time how sweat equity holders are treated within your business. This should include how sweat equity is calculated, what voting rights these equity holders receive, how their profit shares are determined, and any other specific rights or duties they have within the business. Having this clearly defined can prevent confusion or disagreements down the road.
In addition to outlining all details in your operating agreement, your business should also establish a sweat equity agreement. It is extremely important that sweat equity agreements are detailed and written down as early in the process as possible. Too often, the involved parties rely on vague promises and handshake agreements, which can lead to serious disagreements down the road. Clearly spelling out what is expected of the employee and exactly how much they will be compensated is critical. Here are some items to consider including in your sweat equity agreement:
- Type of Equity: What type of equity will the employee receive and how much are you offering?
- Define Performance Criteria: What must the employee do to receive their equity?
- Decide on a Vesting Period: How long must an employee work with the company before they receive their equity?
- Separation Stipulations: Who can break this agreement and how? What happens to the employee’s equity in the event of separation from the company?
Both the company and the person providing the labor or services will likely have to pay taxes in a sweat equity agreement. Taxes will be based on the value assigned to the equity. For example, if an individual provides consulting services that the sweat equity agreement values at $100,000, this amount is taxable in the same way that a $100,000 cash payment would be.
Because sweat equity is non-monetary compensation taxed like regular income, recipients cannot set aside a portion of it to cover their tax liability. This can create a disadvantage to those accepting sweat equity payments.
One way to potentially lessen the burden of sweat equity taxes is to issue the equity as close to the business’s formation as possible. Providing sweat equity payments before issuing equity to venture capitalists or other investors can ensure they are paid out before the company’s valuation increases, lowering their taxable value.
Another way to lower the tax burden is to offer interest in future profits instead of traditional equity in the company. In this situation, there is no current value and, thus, no taxable income.
Adding a partner via sweat equity can be incredibly useful for some businesses, but it isn’t necessarily a good fit for everyone. Here are some pros and cons to consider:
Benefits of Sweat Equity
- Saves money: Many young companies are short on cash and looking to cut costs any way they can. Offering equity in the company as compensation can lower expenses while your company grows and becomes more profitable.
- Attracts talent and skills: Offering equity can entice valuable employees that you might not otherwise be able to afford. This can be very useful for a young company in need of a particular set of skills or connections.
- Creates incentives: Since the value of an equity stake will increase as a company becomes more valuable, those who are compensated with sweat equity may be even more motivated to do their best work to help the company succeed.
Drawbacks of Sweat Equity
- Difficult to value: It can be difficult to form a consensus on how to value sweat equity. Is it simply worth the salary someone can earn in a given position? Is it the amount of additional value that person’s work adds to the company’s valuation? In the end, sweat equity is worth what each business decides it is worth.
- Can lead to disputes: The ambiguity that surrounds the valuation of sweat equity can lead to disputes within the business. Employees may think their contributions are worth more than the company is willing to compensate. This can lead to tension, which can negatively impact the company as a whole.