Sweat Equity Agreement: All you need to know
A Startup is typically formed by two or more founders who come together to build on an ingenious idea. Each one specializes in a particular field and together they are a team of dynamic individuals with a shared dream. Some Founders may contribute in financial terms while others contribute intellectual property. But how do you acknowledge each one’s hard work without the initial cash funds typical of new startups?
The Solution is in understanding sweat equity and sweat equity agreements. Valuing and rewarding the efforts of founders by offering shares in a company is sweat equity. And a sweat equity agreement is a document that legalizes the terms of this exchange. Knowing the value of your startup is an important tool for hiring new talent and attracting investors. It gives your startup the necessary leverage in negotiating investment terms. Let us first try to understand the concept of sweat equity.
A startup is a cohesion of multiple talents. Each one is a crucial piece to the collective success of the business. Though finance is key, not all founders will contribute in cash. Their intellect, expertise, acumen, and time invested in the business are fundamental capital as well. Understanding and knowing how to calculate sweat equity are essential to operating a successful startup.
What is Sweat Equity?
Sweat equity literally means rewarding the sweat off one’s brow. It is a fair medium to acknowledge all non-monetary contributions by employees to the business. Since it is an intangible entity, valuation of sweat equity has to be done with utmost care so that an employee’s contribution is sufficiently compensated for. The terms of compensation for sweat equity are legalized by a sweat equity agreement.
Initial hires in startups operate on below-market salaries. Acknowledging their contributions by offering equity is an economic alternative to cash compensation. However, companies may run the risk of overvaluing sweat equity in the early stages. As a result, they might face a share deficit for later-stage investors. It is important for startups to know how to calculate sweat equity as it lays a strong foundation among stakeholders for building value in the business.
Why is Sweat Equity important?
Failing to evaluate sweat equity is as good as undervaluing your employee’s hard work. If non-monetary contributions are unaccounted, it will affect the valuation of the entire business. Thus, sweat equity helps to monitor the company’s financial health. Sweat equity agreements ensure that all parties bound by it commit to their contributions and are rewarded by the business. Sweat equity can be an integral part of a startup because:
- Equalizer – Sweat equity legalized by an agreement value all forms of contributions of the founding team. It monetizes expertise beyond financial aid. It also ensures that all founding team members feel valued for their respective investments.
- Claim to Equity – As a startup, you are unable to provide cash compensation as in line with industry standards at the beginning. But you need skilled talent who commit to building the business. If you know how to calculate sweat equity right, you can evaluate all efforts of the founding team and offer equity as compensation. Owning shares in the company becomes profitable for new hires in the long run as the business grows.
- Increased company valuation – As a startup, if you know how to calculate sweat equity, you will realize that the value of your business is higher than the money invested in it. Based on this calculation, you can raise funds without risking debt accumulation. For example, if your startup has a cash investment of $X and a combined sweat equity value of $Y, the total worth of your startup is now $(X+Y). If you sell 25% shares to an investor at $(X+Y), your company is now worth $ 4(X+Y). You just created ‘free money’ by selling shares to your investors.
Sweat Equity Agreement
A sweat equity agreement does not have a monetary value as it is. Once you recognize the sweat equity of an employee, this agreement ensures that the parties involved stay true to their commitments. To ensure transparency in this arrangement, it is crucial to spell out the terms on a mutually agreed legal document. But how does this agreement work and what terms must be included in it? Let us explore this one by one.
What is a Sweat Equity Agreement?
A founder’s sweat equity is their fundamental contribution to the startup and their rights have to be protected. A sweat equity agreement is a legal document signed by the partners that protects their right to equity in the company. It is important to have such an agreement between partners at the initial stages of the startup.
Why do you need a Sweat Equity Agreement?
A simple way to create a startup is with two partners. One contributes the money while the other contributes hard work. The next step is to determine the sweat equity value. The sweat equity agreement between partners will make them liable to access shares to business profits. It will equally make them liable to losses.
Sweat equity agreements can also pave the way for a business structure where the company engages potential stakeholders who can only contribute their skills. These stakeholders will receive shares in the company as compensation for their ‘sweat’ investment and gain profit as the business succeeds.
What terms should be included in a Sweat Equity Agreement?
Startups should state clear terms before entering an arrangement with sweat equity partners. Clarity about one’s contribution will set realistic expectations. Some important terms considered while designing sweat equity agreements are:
- Vesting period – In a startup, the vesting period for partners and early-stage employees is decided based on their expertise and extent of commitment to the business. A founder can receive 25% equity as a sign-on bonus with no ‘cliff’ while an employee with 30% equity might have to wait for the ‘cliff’ and further two years before 100% share ownership.
- Type of Equity – The allotment of the type and quantity of shares align with the vesting period decision. These terms will vary in the sweat equity agreement based on the partner’s expertise and value-added to the business.
- Performance criteria – It is common for senior talent in a startup to take up multiple roles. It takes a while for startups to reach a stage where specialized hiring is possible. Thus while designing a sweat equity agreement, it is important to clarify the job expectations from a high-potential resource.
- Separation Criteria – If not planned well, exiting a startup arrangement can be messy for a co-founder. If one of the founders leaves midway for reasons unforeseen, it does not discount any of their efforts until that time. Thus a sweat equity agreement should accommodate fair exit plans as well.
Determining Sweat Equity Value
Before diving deeper into how to calculate sweat equity, it is important to assess the candidate you plan to evaluate. Understanding an employee’s work experience and their potential contribution to the business will determine their sweat equity. As a startup, you should avoid making the mistake of overvaluing a new hire. Such mistakes for an early stage company will cost dearly later when you will actually need stock options to attract investors. Before evaluating sweat equity, some basic aspects you should look for in a potential employee are:
- The will of long-term commitment
- The capacity of contribution (skills, experience, expertise, network, leadership, etc.)
- The passion for co-visualizing the startup’s success
How to determine the value of your Sweat Equity?
A startup can easily slip into a cycle of investor driven validation. But sweat equity evaluation is an area where you should steer clear from an investor’s opinion. More often than not, investors tend to undervalue the company. Then how do you calculate sweat equity? The sum of money and sweat equity invested in your company is not the market value of the business. As a founder, only you are in a position to do a just evaluation of all your contributor’s hard work. Here are some pointers:
- Business valuation – Before creating sweat equity agreements, a startup should have sufficient industry knowledge. This helps in business valuation which is the foundation of sweat equity calculation. Other factors which determine business valuation are geography, competition, and startup capital, to name a few.
- Stock value – Suppose your business is worth $200,000 and you are offering 10,000 shares. Thus each share is worth $20. If your product head, Kate, is contributing $20,000 worth of her time, her sweat equity is valued at 1,000 shares of the business. This is a simple example of how to calculate sweat equity.
- Determining Sweat Equity – A baseline to calculate sweat equity is ‘foregone wages’. This is the compensation an employee received in their previous job. If Kate was drawing $20,000 in her previous job and has to additionally manage two interns to handle workload in the startup, she can ask for a premium on the ‘foregone wages’. The sweat equity agreement will thus value her cumulative sweat equity to $22,000, accommodating a 10% premium. Kate now owns rights to 1,100 shares of the company.
Note: A Startup should know how to evaluate potential hires.
A promising employee need not be appointed a high value just to impress investors. Precise Sweat Equity evaluation is possible only after a sensible talent evaluation.
Sweat Equity Example Calculation
Now that we have a fair understanding about sweat equity as a concept and how to determine it, it is quite clear that precise calculation of sweat equity is actually one of the baselines for valuation of the entire business. Not factoring the sweat equity component can have disastrous consequences, leading to underselling the company to an investor. Let us take an example to see how this works.
Imagine you have invested $2 million in your startup. An investor offers another $300,000 for 10% equity.
The easiest way to calculate sweat equity is to divide the investor’s contribution by the percentage of equity it represents. In this case, $300,000 divided by 10% is $3 million. Since your investment was already $2 million, you just created $1 million worth of sweat equity which will help you recruit deserving new talent. And a sweat equity agreement will legalize the offerings.
Record your Sweat Equity with Eqvista
Sweat equity agreements are one among the million things a startup founder has to manage. Not everything can be done in-house. This translates into coordinating and depending on the expertise of multiple consultants. Would it not be easy to have all these services available in one basket?
Eqvista is a sophisticated equity management software that allows companies, investors, and company shareholders to track, manage, and make intelligent decisions about their companies’ equity. We enable seed-stage to pre-IPO companies to manage equity electronically to capture all shareholder activities. We specialize in company setup, company valuation, company funding, and employee shares management. With our sophisticated software, we ease the burden of busy founders and allow an efficient and cost-effective way to manage their company shares. Sign up for our app today! To know more or understand any other process, check out these support articles or contact us today.