What is Sweat Equity?
In the context of startups, sweat equity typically refers to the portion of the business owned by early-stage employees, founders, or investors in exchange for their contribution of time and effort. In many cases, an employee may not be able to afford to work at a startup in a traditional sense, and so agrees to take less pay or none at all, in exchange for an ownership stake in the company. Also, many investors such as venture capital funds may invest significant sums in an early-stage company in exchange for equity. In other words, sweat equity is a term used to refer to the services provided by startup employees that don’t receive salaries during the time they’re working until the company can afford to pay them. It is especially popular with startups.
Sweat equity can also commonly apply to small businesses and other non-tech entities. The most common examples in these entities are for owners who spend time building the business rather than taking a salary or paying a set fee for services rendered . If a business owner spends four hours a day building a website for the company rather than paying a freelance web developer $100/hour for that website, then the owner or founder has just created $400 worth of "sweat equity" for that day. Another example of sweat equity is building the following on social media. If an employee of a restaurant spends two hours a day for two months building up the restaurant’s social media presence, instead of paying a social media expert to do it, the owner hasn’t spent any additional money but has also saved $6,000 or $7,000. If an employee of an advertising agency spends a week developing and negotiating a contract with a new client, rather than paying an outside lawyer to do it, the owner may have saved a few hundred dollars, but if the deal is large enough, the ability to save money or to avoid having to pay an attorney for the work becomes a significant amount of sweat equity for that time spent.
Key Elements of a Sweat Equity Agreement
As an entrepreneur, you may have been offered some equity in exchange for certain performance or to make up for a lower salary than you could have received based on your skills and experience. This is known as ‘sweat equity’ as it is essentially a form of payment in which you work for the success of a company, rather than being paid in cash. For example, you may want to grow your skills and experience while working for a start-up or you are offered sweat equity because the company does not have the funds to pay you the market rate for your role. It may be that you have a personal interest in the industry that you are working in and you are willing to invest your time and effort without charging what can be a high salary.
A written agreement is recommended as sweat equity arrangements can include a number of complexities and having a legal contract in place can end up saving you a lot of money in the long run. The exact terms will depend on what has been agreed between the parties but essentially the key components of a sweat equity agreement should include: What will be required from each party in terms of their roles and contribution to the company? How will the equity be calculated? Will any vesting period apply? Will the company have the right to buy back the options at a capped price? What will happen if the company fails and the options are unvested? Will claw back provisions apply? How will disputes be dealt with? Are there any restrictions in place? An employee can be issued with options after a certain period of employment and then these can be converted into shares at a later date (when a vesting condition is met).
Have a clear plan in place with open communication with each employee or contractor. There should be detailed contractual documents in place to avoid any misunderstandings.
How to Create a Sweat Equity Agreement
The process for drafting a sweat equity agreement is relatively straightforward. It is done in three steps:
- Determine what each party is contributing to the company and assign a value to each contribution. The contributions do not have to be equal. For example, if one person is contributing $50,000 and the other person is contributing $25,000, the person making the larger contribution may be entitled to 67% of the equity in the company while the second person is entitled to 33%.
- Determine how much equity will in total be issued by the company in exchange for the contributions. For example, assuming that the total of the contributions equals $75,000 (see step 1) and the parties agree that the company will issue 75% of its equity in exchange for the contributions, then the company itself will keep 25% of the total equity that it has issued – the remaining 75% will be paid for as described in step 3.
- Determine how the parties will pay for the equity issued in exchange for their contributions. There are three common ways: issuance of secured or unsecured promissory notes; issuance of convertible promissory notes and issuance of unsecured promissory notes that convert into secured promissory notes on a specified date. Each different type of note has its own advantages and disadvantages. Also, when drafting the notes, one must always be mindful of the realities of the financing process. For example, if the company is seeking outside financing after the notes are issued, the outside lender may require the notes be converted into secured promissory notes – that is something that we have been seeing for about the past five years. Additionally, it is important to understand what will happen if the notes are not paid by the maturity date. For example, if the notes are not paid by the maturity date it is common for the unpaid amounts to accumulate and not be payable in cash but for the debt to convert into equity in the company. This satisfies lenders under both the IRS and SEC rules and also makes it less likely that the debt will convert into a taxable event for the parties.
Considerations and Legal Requirements
The creation of a sweat equity agreement, like any other agreement, should be done only with the advice and assistance of legal counsel. This is particularly true given that there may be federal and state security laws that govern such an agreement. Qualification under an exemption from securities registration under the federal private placement rules (Rule 506) may be available to compensate claimants for cash or property received in satisfaction of a liability arising from services rendered, as well as to compensate employees, directors, officers, consultants or advisors for services provided to the company, so long as the company is not offering an equity interest to any investors not so employed.
Another securities exception that may apply is the "compensatory offer, sale or grant" exemption. Under this exemption , no limit is imposed on the amount of equity securities that a company can grant to non-employee relationships in any twelve-month period so long as the company does not concurrently conduct a public offering where it accepts payment from the purchasers or otherwise obtains capital from non-employees.
There may be added compliance issues for the Company as well if they choose to use securities. The offeror should determine whether the nature of its securities requires registration and/or compliance under foreign law (both of which may be addressed in the offering in question). The attorneys representing a special committee of independent directors of a corporation should be aware of possible conflicts of interest and what, if any, interests the corporation may have with respect to the transaction in question, particularly if the transaction is for fair market value. With respect to the employment of employees or insiders, counsel should review the corporation’s existing employment agreements, non-competition and non-solicitation covenants, test the agreement for compliance with applicable state and federal laws (and review potential tax implications as noted above) and obtain and keep copies of applicable employee compensation and plan documents.
Pros and Cons of Sweat Equity
Like anything else, sweat equity isn’t without its benefits and drawbacks. If you’re thinking of taking a plunge into the world of sweat equity in your new business, you’ll want to weigh the pros and cons carefully.
The Benefits of Sweat Equity
If you and your partner(s) are doing all or most of the work in the business, then sweat equity can be especially beneficial for tax purposes. If you have employees, you are required to pay those employees a salary. You are also required to pay payroll taxes, employment insurance premiums and so on. No such requirement exists for a business owner. This means that by not paying yourself a salary and instead compensating yourself with equity, you are not only saving yourselves payroll taxes, but also deferring the tax you will eventually pay until you ultimately realize a return on your sweat equity once you make profit distributions to yourselves, which in turn is a lower tax rate than the wages you were otherwise going to take.
The Risks of Sweat Equity
The biggest risk associated with sweat equity is that it’s purely based on speculative value. It’s impossible to determine the precise market value at any given time because a company is only worth what someone is willing to pay for it. For this reason, the CRA considers sweat equity to hold zero value until a capital gain occurs. There are still some dangers associated with it.
One danger is that even if you’re working towards it, building wealth is hard, and it’s even harder to build it when you don’t have any fixed capital contributions. If a new product or service has unexpected costs, you won’t have as much liquidity as you otherwise would have, meaning it’ll take longer to make necessary decisions and investments, including hiring new talent.
It’s important to note that if you’ve signed a contract to sign your company over to someone else, and that person doesn’t follow through, they’re guilty of anticipatory breach and you can sue them for monetary damages. However, if you signed a contract to hand over your company for a share of the ownership, and that person never comes through, you’re out of luck — the CRA will still consider the agreement to be a real contract. If you decide to sue them, the judge will have no choice but to hand your company over to them, regardless of whether you win the case or not.
Sweat Equity Agreement Form
Sweat equity agreements are sometimes complex, and it is not unusual in such documents to see the terms and conditions of a decision which will take effect at a later date or when particular circumstances exist. Luckily, there are templates for sweat equity agreements available which save you time and effort in having to use your own imagination to come up with workable decisions and terms.
As an example, a template for a vesting schedule is below:
Vest [Percentage]% per month for [X] months
[Percentage]% at [Y] months and [Z]% at [Months 1] through [Months 12] at [Z]% per month.
You can simply fill in the [Percentage] and [X], [Y] , [Z] and the remaining fields in the template below.
Employment of [Name of Individual] (the Sweater) and Subscription for Shares
The above-named individual (the Sweater) is hereby employed by the Corporation on the terms and conditions hereinafter set forth. The Corporation agrees to issue that number of shares of common stock in the Corporation as is set forth below opposite the following vesting schedule to the Sweater at the time of vesting of each portion subject to the terms and conditions hereinafter set forth.
To be used as a general guide only, the template does not replace the guidance of legal counsel. CanLii provides blank templates for different types of corporations and a variety of other useful templates.