How a Sweat Equity Agreement Works
A sweat equity agreement is a contract that gives a person partial ownership in a business in exchange for services to the company or its founders, instead of monetary compensation. When companies are just starting and lack the funds to pay workers a salary, they may grant employees shares of the company. Or, an existing employee may be involved in a startup that has not yet begun making profits, and grants an equity stake in exchange for working during his or her off-hours. Such stock grants are sometimes provided as an incentive for high-producing employees to stay with a company through the next phase , such as an acquisition.
Sweat equity agreements are meant to compensate an employee or member of the company from which he or she would otherwise have departed due to unequal incentives or opportunities. A person who takes on the role of founder may be required to leave his or her job until the new venture reaches a certain stage, for example.
In the tech world, most companies hire developers through sweat equity agreements, at least in the beginning phases. Depending on how the agreement is negotiated, these employees will often end up with a share of equity in the company after completing the work they agreed to perform. This is an effective way to compensate people who already have the technical savvy the startup needs, continue to build their skills, and keep them based in one location.
Components of a Sweat Equity Agreement
A sweat equity agreement typically includes the following key components:
Offer. The agreement should explain who is making the promise of sweat equity (promisor) and who is receiving that promise (promisee), and the stated employment or investment role the promisee will hold. The offer should also include an explanation of the type of compensation that will be received in the form of equity and how the equity will be allocated. For example, will it be restricted to preferred stock, or will it be common stock? Additionally, will the equity vest immediately or will it contain a vesting schedule?
Acceptance. Once the promisee accepts the offer, they should sign the agreement and have the promisor counter-sign.
Consideration. The agreement must include an exchange for consideration from both parties in order for there to be an enforceable contract. If only one party is offering something to another, that may constitute a gift, not a contract. A promise to transfer equity occurs when the consideration the company receives is tied to specific performance or service of the individual receiving the equity. For example, consider a situation where A agrees to share her future capital gains equally with B, in exchange for knowledge B has that could significantly increase A’s wealth. Because there is stuff going each way, this could be a valid sweat equity agreement.
Terms. This section should state the terms, such as how long the contract will be in effect and how the agreement will be dissolved generally.
Signatures. All parties associated with the agreement should sign and date the contract.
Advantages of Sweat Equity
For startups and small businesses, the advantage of using sweat equity agreements is that the company does not have to exert cash flow reserves to attract valuable contributors. Startups and small businesses can be cash-strapped for some time after they start or expand. Also, employees and independent contractors tend to go for non-cash compensation when the cash compensation is insufficient to retain their services. In a startup and small business environment, non-cash compensation may include stock and options. Cash is very precious, so it is a win-win solution for the company and the individual to get equity in lieu of cash. Consequently, sweat equity agreements help startups and small businesses to conserve cash and reserve cash for other business purposes. Additionally, equity in the form of stock and options provides for a more durable incentive to employees than other alternatives such as a bonus, as options do not vest immediately. Equity is more appealing than bonuses that are dispersed among employees, as fairness and equity can be difficult to determine among contributions from all participating employees. From the perspective of an individual gaining equity, it can represent future wealth depending on the future success of the employing company. For example, equity in a small business set to grow is very appealing for an employee or independent contractor.
Disadvantages and Risks
For a smaller business, there may be a number of potential drawbacks and risks associated with using sweat equity agreements. First, there is the question of what actually counts as "sweat" itself, given the vagueness of the term. Without a strict definition, there can be questions about whether someone has fulfilled their end of the deal in providing the services and/or time in exchange for equity in the company. This can, in turn, create a situation where what one party (or both) thinks is a fair price for services or time spent or fair consideration for an equity grant can come into dispute and create unnecessary hardship. An investor may wonder if they’ve secured enough equity for the price they’re actually paying, while a service provider might feel they haven’t been fairly compensated for their work.
Further complicating matters is the idea of what is fair, as there can be two different standards of "fairness" to consider. Is the equity fair based on fair market equal valuations? Or is it fair in the sense that each party is operating under full disclosure of the substance of the company, and is therefore entering into the agreement of their own free will, which will not amount to coercive pressure by one party over another? In many cases, the party providing the services does not have full access to the books of company, nor do they really need to. The service provider is not necessarily looking to invest money into the company, just time and effort. However, this can become a problem if the party providing services believes that the company is greatly undervalued while the investor party does not.
At the same time, if the equity cannot be effectively valued, the sweat equity arrangement can simply become another incentive program that fails to capture the true nature of what an employee or contractor is worth and leads to failure to retain talent. If your contractor knows the work they perform is actually worth more than they are getting for it, they may feel resentful of the arrangement while still keeping the services, resulting in lower morale and productivity.
Legal and Common Sense Considerations
When entering into a sweat equity agreement, both the granting and receiving party should be aware of the tax and legal implications of such compensation. For example, the compensation may be treated as taxable income, liabilities may be incurred upon the vesting of interest and legal issues may arise over the enforcement of an agreement. It is, therefore, advisable that both parties seek independent legal counsel before entering into a legally binding agreement. Specifically, each party should consider the following in regards to their agreement.
Duties and Services – A well-drafted agreement will explicitly spell out the services being supplied by the service provider and the value of such services .
Consideration – The agreement should address how much the service provider will receive for their services (i.e. equity, partnership, income, etc.) and when such payment will be supplied.
Full Disclosure – Both parties must enter into the agreement with full knowledge of their respective advantages to and duties under the agreement. If the parties knowingly consent to the terms and conditions of the agreement (which should be done with the full benefit of legal and financial advice), there are fewer grounds for either party to later challenge the enforceability of the agreement.
Real-Life Examples of Sweat Equity
These success stories illustrate how both the company and the employee have benefited from sweat equity agreements:
Grubhub, a food delivery service in the United States, has used sweat equity arrangements to compensate employees who have received below-market salaries. In exchange for their work during Grubhub’s early years, employees were awarded stock options at a favorable price. As Grubhub’s business grew, these stock options became worth far more than the cash salary the employees had given up. Upon Grubhub’s initial public offering (IPO), these stock options were sold, and the employees became millionaires.
USDigital, Inc., is a digital marketing services company. It has a multi-tiered employee compensation plan that includes stock options for all employees. The average number of stock options awarded is 1,000 shares priced at $0.01. These options vest over four years and carry a ten-year term. If the employee leaves the company before his or her options vest, then the remaining unvested stock options are forfeited. Over the past five years, USDigital stock options have more than doubled in value.
The success stories of Grubhub and USDigital demonstrate the importance of considering a variety of compensation strategies for start-ups. Many start-ups find themselves in the unfortunate position of having to choose between growth and paying employees. While sweat equity cannot solve all the challenges that start-ups face, for some companies it provides a flexible tool to overcome some initial compensation challenges.
Sweat Equity Agreement Drafting Tips
When drafting a sweat equity agreement, it is important to clearly outline the specific terms and conditions of the agreement. Here is a step-by-step guide on how to draft a sweat equity agreement:
- Identify the Parties – Clearly identify the parties involved in the agreement, including their roles and responsibilities.
- Define the Project – Clearly outline the project for which the individual will be providing their services and outline the expected duration of the project.
- Outline the Terms of the Agreement – Clearly stipulate the compensation, equity percentage, payment methods, and other terms of the agreement.
- Include Confidentiality Requirements – If the project involves sensitive information or materials, a confidentiality clause should be included outlining the limitations on sharing confidential information.
- Incorporate an Exit Strategy – Include a clause explaining the terms under which either party can terminate the agreement .
- Consult with Legal Counsel – It is always recommended to have the agreement reviewed by a legal professional to ensure that all parties are protected.
Negotiating the terms of a sweat equity agreement can be complex, but here are some tips that may help:
Determine an accurate fair market rate – Take the time to research what similar roles are being paid for within the industry to determine if the rate is competitive.
Set specific performance standards and goals – To avoid any future disputes, establish specific goals and deliverables that need to be met within the specified time frame.
Be clear about what is and is not negotiable – Before entering into any discussions, know which terms you are willing to compromise on and which terms are critical to the success of the deal.
Have an attorney review the agreement – Before signing the agreement, make sure an attorney has reviewed the terms to ensure that they are fair and in your best interest.