Should I work for Sweat Equity?

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.

 

This Post Has 7 Comments

  1. The short anwser is yes if you have the right people involved and depending on what they contribute.

    However, every single early stage investment has sweat equity in the mix. The person starting the business has put cash and sweat into the mix and that is often undervalued by cash only investors.

    Time is money. It’s still surprising to me that investors don’t see it this way. Sweat equity should probably be valued more highly than early stage cash being “sweated” by an early cash only investor. Often there is no cash to invest so Hobson’s choice.

    I make no intrinsic distinction between the cash and sweat investors. There is many a sweat investor that is much more valuable to the business than the poor sod with his “house on the line”, which is not a good metric at all for me. Often a marker for an investment designed to fail.

    At times sweat has gone in from a service provider because it was far more valuable to the business than any cash the individual or anyone else could have introduced at that time and at the time the business had no cash. I work with many of those!

  2. The Hard Cash point you made doesn’t take account of risk sharing. If I am building a business and decide to offer a stake to an investor when I have money of my own. It is simply sharing the risk of the business to succeed. The business will always have risks and failure will always be a possibility. By sharing the risk with an investor I am simply saying that I am putting in the hard work and if you think this model will be successful why don’t share the risk and we both can make some money.

    I hope this answer why you can expect me not to use my own money to build my own business.

  3. Nick, many thanks for your valuable comments.

    I agree with you, an investor with “house on the line” is a poor metric for me too. In fact, I’d be worried if an investor did have his house on the line since this is one of the highest risk investments that can be made so investors should only use spare, non-essential cash that can be written off without any problems. It’s different if the founder or entrepreneur who believes that his plan will work though.

    Interesting to hear that many service providers are happy to accept equity rather than cash. How do they go about valuating how much equity they need? Are the shares held personnally or by their companies? Do they end up with lots of shares owned by their companies over a period of time? Have they managed to receive their fees eventually?

  4. Many thanks for yoru comment Zulfiqar. However, if you believe that your business will return x10 the amount invested in 3 years, why would you want someone else to put their money in rather than you? Why wouldn’t you want you £10,000 to be £100,000 in 3 years time?

  5. Brian,

    I think you have the wrong end of the stick on my post! I was referring to investors who expect the person looking for investment to have his/her house on the line. I think investors spend too much time worrying about valuations and proportionality on contribution. The money only investors will ALWAYS be adding less value.

    Equity they need? Entitled? Valuing sweat is easy for service providers. You work out their contribution at their normal charge rates and they get equity pari passu with cash investors for what they contribute. Shares are often owned by companies. They do get exits. I know of one that took £10,000 sweat pari passsu with cash investors in a total of £50,000 (so £40K cash)to a return of £300K for his £10K.

    Increasingly I find that those looking for angel investment are looking for more than money. Angels often sweat invest also but see know real value for their sweat….they argue they are looking after their investment. That’s just bad investing!

    With refernce to Zulfiqars’ comment. The answer to your question Brian is that time is worth more than money in his example. Why should he put time and cash into the mix pari passsu with investors cash?

  6. Nick,
    When looking at a proposition from an entrepreneur I look at the “pain” that they will feel if the company fails. A deal where the entrepreneur can walk away into another job (which he’s been keeping running in the background) only losing some time and energy while I lose all my money does not look so good to me. A deal where the entrepreneur says it is too risky for them to invest their own spare cash suggests that it is too risky for my cash too.

    You make the point that it is easy for professionals to value their sweat. True. What about Business Angels? No formal qualification, no qualification required to practice, high variety in scope of advice (i.e. not just accounts or legal), where the majority of value comes AFTER the investment (not at investment date as with professionals). How do they value their time?

    I think the key is in your comment: “Increasingly I find that those looking for angel investment are looking for more than money.” But are they expecting to pay for it? And are they expecting to pay market rates for it? If so, what is the market rate?

    I have observed that there is considerable resistance to an investor offering an investment and then asking market rate fees for mentoring, coaching, advice, contact lists, etc. Entrepreneurs seem to expect these to come for free from Business Angels. Perhaps this is an unreasonable expectation?

    In Zulfiqar’s case, the deal he is offering is to transfer risk to the investor for an eventual return (over which the investor has no practical control). At the same time, by not putting his own money in, the entrepreneur is saying that the risk is too high for his money. And he has all the control…

  7. Time is money and the way you need to calculate is based on opportunity cost. In the amount of time you spend for building sweat equity, you maybe missing out on other things. This could be making money flipping burgers or moonlighting for cash, undergoing formal training, seearching for better opportunities or even spending time with your family. There are tangible and intangible benefits you give up. You need to find the cost of what you give up and calculate how much money would compensate you and give you sufficient profit. Then you need to accommodate risk factors and calculate how much money you are realistically going to make from that sweat equity when you choose to exit. Then find which is higher, what you give up in opportunity cost or what you will get from that sweat equity.

    Invariably you will see that the person who benefits the most from the sweat equity is the entrepreneur. My strong recommendation is that if you wish to sweat do it for your own company rather than someone else’s.

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