Sweat equity agreements allow early stage startups to attract and incentivise skilled team members. Here’s what you need to consider before offering sweat equity agreements at your startup.
Startup founders and entrepreneurs are often challenged by their budget — retaining key team members or co-founders while ensuring sufficient growth capital remains available can be a difficult task. Businesses or startups in pre-revenue or critical growth stages can often struggle to retain key staff members while maintaining a stringent budget.
Many startups and early stage businesses overcome this problem by establishing sweat equity agreements. What are sweat equity agreements, though, and how do they work?
What is Sweat Equity?
Not all contributions to a business are financial in nature. Anybody who works for a startup, company, or business contributes to its overall value. By increasing the value of a business, an employee, team member, co-founder, or contractor contributes to the equity of a business.
In most cases, employees and team members are rewarded for their contributions with fiat currency — most employees aren’t owners, and most startup founders don’t intend to make every team member one.
Sweat equity agreements, however, reward contributors to a business with equity. For example — a startup may be founded by two individuals. One individual may contribute $100,000 in startup capital, while the other does all the work. Should the startup be worth $300,000 after three years, the threefold increase in value is primarily due to the second individual’s hard work.
The “equity” element of a sweat equity agreement refers to ownership in a business. “Sweat,” contextually, is the work a team member executes in order to add value to the business.
What is a Sweat Equity Agreement?
A sweat equity agreement allows businesses to provide employees or contractors with shares in a company in lieu of dollars for their work. In a sweat equity agreement, a contractor or employee enters a contract with a company that provides them with equity in return for services rendered to the business.
When Should a Business or Startup Use a Sweat Equity Agreement?
Sweat equity agreements are used in a variety of situations, and are widely used in the startup ecosystem to engage talented workers that may otherwise be out of the HR budget of a growth-stage business. Many tech startups, for example, use sweat equity agreements to hire on talented software developers.
Sweat equity agreements are attractive to prospective team members and employees that believe the value of the company offering the agreement will grow in future. A company offering sweat agreements must present compelling evidence that the value of their company will grow to a level at which the equity offered to a prospective worker is commensurate with the work they contribute.
Startups with strong growth potential are best suited to the use of sweat equity agreements, as most prospective team members will view a sweat equity agreement as a high risk, high reward investment.
Sweat equity agreements can also be used when forming a partnership. A new business formed as a partnership generally involves each partner contributing value — some partners will bring start-up capital, others will bring experience and labor, and some partners will deliver both.
A sweat equity agreement allows business founders working in a partnership to ensure that the value in a business is distributed fairly.
What Should a Sweat Equity Agreement Cover?
- Sweat equity agreements should be composed clearly and with allowance for future contingencies. A sweat equity agreement must cover a variety of clauses, which can include:
- Total equity: How much equity can be earned? For example, startup co-founders may want to limit the total amount of equity that may be earned to 50 percent in a two-person partnership. Larger companies will often set the total amount of equity that can be earned at a lower level.
- How fast will equity accrue? It’s important to set the specific rate at which equity is accrued in the agreement. This can be based on salary or rate of pay — an individual with a salary of $50,000 per year, for example, may be provided with this much equity at the end of the year instead of a salary.
- How will work convert to equity? What is the rate at which sweat will convert into equity? This can occur monthly, every six months, or annually. This factor can affect corporate governance.
- Will the agreement include a vesting period? Some startup founders may not want team members to access equity immediately. A vesting period can delay the time period in which an individual beings earning equity, with traditional salary payments in the interim.
- Equity type: Different company structures may have different types of shares. It’s important to clarify the type of equity received in the agreement.
- Performance: What are the responsibilities of the team member? The role and responsibilities of team members should be clearly defined.
- Milestones: Startup founders may want to specify specific milestones that must be reached before team members are granted equity, such as the completion of specific systems or development roadmap milestones.
It’s important to include a section that defines separation criteria. Employees and team members transfer occurs rapidly in the fast-moving startup environment, so a sweat equity agreement should define what happens to equity in the event of separation.
What to Consider Before Offering Equity
- Before you establish a sweat equity agreement, there are a number of factors that should be considered:
- Commitment: How committed to your business is the prospective team member? It’s important to offer equity only to talented, enthusiastic prospective team members that are vocal and active in early business discussions.
- Value: How will the prospective team member increase the value of your business? Startup founders should carefully consider the benefits and value that any sweat equity agreement could bring to their business.
- Alignment: Sweat equity agreements place a portion of your business under the ownership of another individual. It’s important that stakeholders in your business share your vision, strategy, and long-term business goals.
What are the Main Considerations of Sweat Equity Agreements?
While sweat equity agreements are highly attractive to startups, there are a number of important legal considerations that must be taken into account.
All businesses in Australia must adhere to Australian employment laws — while sweat equity agreements are a powerful way to attract and incentivise new team members, it’s important to ensure that your business is compliant with Australian employment laws and regulations.
- Sweat equity agreements must be clearly defined in a compliant manner. If a worker is employed in Australia by a startup, the startup is legally obligated to pay the employee minimum wage. Before establishing a sweat equity agreement, startups should consider:
- Whether the worker is an employee
- The minimum award of the employee
- What the legal entitlements of the employee are
If you’re interested in more information about the legal structures that govern equity distribution with team members in a startup environment, you may want to examine both Employee Share Scheme (ESS) and Employee Share Option Plan (ESOP) options. To learn more about these options, take a look at Fullstack’s guide to Slicing the Pie – How ESS and ESOP arrangements work.
Business Structure Requirements
Not all Australian businesses are able to issue equity to team members. Sweat equity agreements are only possible for businesses that have a company structure in place — it’s not possible to establish sweat equity agreements for sole trader or partnership business structures, as these structures do not have any equity to distribute.
For more information corporate structures and shares, see Fullstack’s guide to Corporate Structures: Choosing the Right One or Company Structure: Founders Shares vs Ordinary Shares:
The creation of a sweat equity agreement may necessitate a shareholder’s agreement. Workers that establish a sweat equity agreement with a company may need to sign a business shareholder’s agreement, which is a contract between the company and all of its shareholders.
- A shareholder’s agreement establishes the rights and obligations of shareholders, and covers factors that include:
- How many shareholders are there?
- What is the distribution and proportion or shares?
- What is the relationship between key stakeholders, such as directors and shareholders?
- How is governance organized, and how are disputes managed?
- What happens when a shareholder wants to exit?
Equity incentives are a powerful way to motivate new team members. Sweat equity agreements, if composed correctly, can help early stage startups attract and engage talent that may otherwise be unavailable. In many cases, sweat equity agreements are established in order to offer talented workers a lower salary than would otherwise be offered in return for an ownership stake in a business.
Before issuing equity in your company, however, it’s essential to understand the various legal requirements associated with sweat equity agreements and how best to structure your agreement to provide the best result for all parties.
If you’re considering establishing a sweat equity arrangement or are unsure of your obligations as a founder, reach out to Fullstack today for comprehensive guidance and advice.