Investing time instead of money in order to get equity? Sounds like a good plan to me. If things go wrong, I’ve not lost any money. Or is it a good plan? What are the pitfalls for the sweat equity provider, future investor and the entrepreneur? What questions should they ask each other and what should they be aware of?
When someone works for a company and is paid in shares instead of cash, they have received Sweat Equity. In other words, they have exchanged “sweat” for “equity”. Some companies offer share schemes which allow employees to receive shares for their work and this is usually considered part of the remuneration package (and this term is not used). “Sweat Equity” is usually reserved for deals where the majority of payment for work is through shares which provide future value when the company exits.
The following table contrasts the benefits and pitfalls for each person in the deal – the provider of Sweat Equity, the company or entrepreneur that receives the sweat and how a future investor may look at the transaction at a later date (in no particular order).
|Sweat Provider||Recipient Entrepreneur||Future Investor|
|No loss of cash if things go wrong (compared to investing).||Quick way to fill a gap in the management team with no hard cash changing hands when company is least liquid.||Not sure how much value has been provided for sweat equity.|
|Avoids putting a value on the company.||Avoids putting a value on the company.||Means the company has to be valued twice: when sweat equity agreed and for this investment round.|
|Quick to start.||Quick to start. Feels easier to terminate since no employment contract & rights to consider.||Extends negotiations.|
|Fun.||Sharing a burden makes life easier.|
|Can offer advice without responsibility for it.||If the advice isn’t followed, relationship could sour.||Increased due diligence to establish who advisors are.|
|Perceived little personal risk (beware Shadow Directorships).||Little risk to company (until shares are issued).||Management team members may not be aligned if they don’t all have some risk.|
|Can build large portfolio of companies at little cost.||Once shares issued, no control over quantity and quality of service provided.||If investor provides help, should he receive additional shares? If so, how many? For what?|
|Can stop once shares received.||Once shares issued, less compulsion for provider to continue.||An additional team member to work with.|
|Difficult to exit.||Difficult to recover shares on success or failure of relationship.||Additional work on agreement to cover different shares (a separate class?)|
|Large upside if things go right.||Does the final reward match the input?||What about future funding rounds? Enough equity left?|
|Fills time but the time has no value (so no income).||What milestones/goals should be in place for shares to be handed over?||What is sweat provider’s monetary contribution to date? And in the future?|
Propositions where there is an element of sweat equity proposed or already included, I would make the following observations:
- Due Diligence. I would not pool my due diligence with the sweat equity provider. I would want to do all my own due diligence and be especially keen to value the equity provider’s contribution. I look at them as a member of the management team but without the “house on the line”.
- Hard cash. If someone putting sweat equity into a deal doesn’t put their own money in, I’d want to know why they thing the company is too risky for their cash, but not too risky for mine.
You will find many other pages on this website that will help you – for example:
- How Much is an Idea Worth?
- 6.5 Steps from Startup to Success
- 6 Reasons why “Exits” Don’t work
Should you have any more questions, please call me or drop me an email using the Contact Us page.