The concept of sweat equity has been around for a long time, but it has become more popular in recent years as startups have become more prevalent. Sweat equity enables the founders, employees, and other individuals associated with an early-stage startup to earn equity in it without having to invest their own money, like an angel investor. Sweat equity rewards these individuals for putting in the hard work required to make a startup successful. In this guide, we break down all the ins and outs of sweat equity, the common pitfalls to avoid, and more!
What does startup sweat equity mean?
Sweat equity shares are a type of compensation that startup founders and early employees receive in exchange for their hard work and dedication to the company. It is a way for these individuals to receive compensation in addition to or in replacement of a salary, which is especially helpful for cash-strapped startups. Sweat equity is usually given in the form of stock options or restricted stock units in a company. In some cases, it enables founders to gain a stake in the company without having to put in money of their own.
What does sweat equity in real estate mean?
The term ‘sweat equity’ is also used in real estate to describe the literal physical labor and time someone puts into building their own home or improving a property. This could be anything from renovating a kitchen or bathroom and landscaping its yard, to completely gutting the inside of a home. The person who contributes the labor is then rewarded with a stake in the property. The property or business owner benefits from a lower cost of repairs and the individual completing the repairs earns a stake in the property without being forced to make a monetary contribution towards the piece of property.
Why do startup founders like to use sweat equity?
Startup founders are often very passionate about their companies and are willing to put in the extra work to make them successful. Sweat equity allows them to be rewarded for their efforts without having to put any of their own money into the company. The equity they earn can be in addition to or completely replace the salary they would’ve earned.
How does sweat equity work?
Sweat equity in startups works in much the same way as it does in real estate. Founders are rewarded with a stake in the company in exchange for their hard work and dedication. This could be in the form of stock options or direct equity in the company. The amount of sweat equity that a founder receives is usually determined by their contributions to the company. Founders or early employees who put in more work or more meaningful contributions generally receive more equity than those who put in less.
How is sweat equity calculated?
The amount of sweat equity that a founder, early employee, consultant, contractor, or agency receives is usually determined by their contributions to the company. This could be decided based on the number of hours they worked or what their work was worth. In some cases, agencies will swap their entire retainer for equity in a cash-strapped or early-stage company.
What are the general terms of a sweat equity agreement?
A sweat equity agreement is an agreement between a founder, early employee, or other individual and the startup that outlines the terms of the arrangement. These agreements typically include the following items:
- The number of shares that the individual will receive
- The vesting schedule of the shares
- The rights and responsibilities of the individual
- The rights and obligations of the startup
- The duration of the agreement
- The termination clauses which end the agreement
What are the benefits of sweat equity for startup founders?
There are many benefits for startup founders who choose to use sweat equity as a reward for their hard work. Some of the benefits may include:
- Ability to earn a stake in the company without having to put in money of their own
- Ability to be rewarded for their hard work and dedication
- Ability to have a say in the decisions of the company
- Ability to receive upside in their initial investment as the company grows
What are the drawbacks of sweat equity for startup founders?
Although there are many benefits to sweat equity, there are also some drawbacks. Some of the drawbacks include:
- There is no guarantee that the company will be successful, so if the company fails, the individual will not receive any return on their investment
- The individual is not guaranteed to have any control over the decisions of the company
- The individual is not guaranteed to have any say in the company’s finances
Sample sweat equity agreement template
Here is an example of a sweat equity agreement for illustrative purposes only. Before using it, consult legal counsel.
This agreement is made between [Founder] and [Company], hereinafter referred to as “The Parties”.
The Parties agree that [Founder] will receive [X] shares of [Company] in exchange for their work and dedication to the company. The shares will be vested over [X] years, with [X] shares vesting each year.
The [Founder] will be granted the following rights and responsibilities:
- The right to participate in the company’s business decisions
- The responsibility to adhere to the company’s policies and procedures
- The responsibility to act in the best interests of the company
The [Company] will be granted the following rights and obligations:
- The right to terminate the agreement at any time
- The obligation to pay the [Founder] in the form of equity
- The obligation to provide the [Founder] with information regarding the company’s financials
This agreement is effective for [X] years and can be terminated by either party with [X] days’ written notice.
Determining the value of sweat equity?
The value of an individual’s sweat equity is determined by a company’s valuation. The higher the company’s valuation, the more the equity that the individual received is worth. To calculate the sweat equity value, the company usually contracts a 409a valuation from an outside party.
Common pitfalls of sweat equity
When it comes to sweat equity, there are some common pitfalls that founders should be aware of. These include:
- Not having a clear agreement in place: It is important to make sure that all the terms of the agreement are clearly outlined and agreed upon by both parties.
- Not understanding the risks: Relevant individuals need to understand the risks associated with investing in a startup, including the loss of their capital.
- Not seeking legal counsel: All documents, including a sweat equity agreement, should be reviewed by internal or external legal counsel.
Final thoughts on sweat equity
Sweat equity is a great way for startup founders and the early employees of a startup company to get rewarded for the time and effort they put into making the company grow. It is a way for these individuals to gain a stake in the company without having to put in money of their own. It is important to make sure that the terms of the agreement are clearly outlined and agreed upon by both parties so that there is no confusion. It is also important to make sure that the individual understands the risks and obligations of taking on sweat equity. Overall, sweat equity can be a great way for founders to attract and retain top talent when launching a company.