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. This equity is meant to be compensation for their hard work (or “sweat”).
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 incentive: 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.
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.
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:
- Vesting period - How long must an employee work with the company before they receive their equity?
- Employee performance expectations - What must the employee do to receive their equity?
- Type and amount of compensation - What type of equity will the employee receive and how much are you offering?
- Terms of separation - 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.
If you’ve been offered sweat equity in a company, there are some important things to consider before accepting.
First, consider the risk involved. While receiving equity in a new company has the potential to provide large payoffs down the road, there is no guarantee the business will succeed. If the value of the company goes to zero, so does the value of your shares.
Second, you’ll need to determine if it’s feasible to work for an extended period of time without taking a full salary. Even if you are certain that your equity in the company is valuable, that value is only on paper until you sell the shares. Before entering into a sweat equity agreement be sure you’re in a financial position to do so.