Sweat equity – how to make the most of it

Owners of start-ups often ask me for advice on if and how to pay senior experts in so called sweat equity. So here is my short and sweet on the topic that I hope can be off some general guidance.

There are many challenges for start-ups and scale-ups. One being liquidity. Another being attracting top talent and senior experience needed when growing the business, since offering a competitive renumeration package will be expensive. Sweat equity can provide a solution for both of these issues.

But firstly – what is sweat equity? It is when a person (or company) is paid for its services in equity – typically shares or options – instead of being paid in cash.

The use of sweat equity comes with some clear advantages, but also with some challenges. Here is a summary of some key aspects to be aware of when considering handing out or receiving sweat equity as compensation for services.

The good:

1. It will not affect the liquidity of the company. Instead, a share of the ownership is given. This can be instrumental for many start-ups who do not have the spare cash to compete with more established companies as regards engaging top competence.

2. It will typically establish a more long-term commitment/incentive for the person receiving sweat equity, since the recipient stands to gain from the company growing in value. I.e. skin in the game for the expert that gets the long-term investment – really getting the opportunity to participate in a company’s success that he/she is expected to help create in a significant way.

3. Lower risk/overall costs than having specific expert competence on the payrolle also since; if given to an external expert, no social security charges will be incurred and no long term obligations of paying a fixed salary etc will occur. While the same principle of lower risk goes for cash payments to an external consultant, as mentioned sweat equity helps minimize impact on the company’s liquidity.


The issues that need a think-through:

1. VAT. Typically VAT will need to be added on the invoiced amount and needs to be paid to the tax authorities in cash by the expert. It can therefore be helpful if a cash portion is paid to cover at least the VAT part, as VAT is to be paid even if the expert has not gotten any cash only equity.

2. Corporate tax. The expert may need to pay corporate tax on the value of the sweat equity. Also for this reason, it may be preferable to receive a portion of the compensation in cash to bridge this dry income issue.

3. For the expert there is no liquidity. When accepting sweat equity, the possibility to realize the holdings is often highly limited since it is typically a privately held company that is the issuer, and also transferability of the shares is often restricted through a shareholders’ agreement. If you as an expert absolutely need liquidity now, over long-term value e.g. for paying your own salary, perhaps sweat equity is not right for you.

4. The cap-table. Having the right list of experts on the cap table can often strengthen the company. But if too many small chunks of sweat equity are handed out, this can make the cap table somewhat messy (which is not favourable in an exit process etc). Therefore, consider saving sweat equity for those experts that can bring key competence or those that bring a strong network.

5. Company valuation. My recommendation is simple – stick to your standard valuation principles. If you e.g. have done a fundraising recently, use that as basis for your valuation unless there are valid reasons to adjust it. While dilution of current shareholders can be an issue, unless the sweat equity would amount to a significant part of the company it can still in many cases be an attractive solution.

6. Performance & valuation of the work provided. Once the work has started and/or the equity has been transferred it can sometimes become apparent that the parties have different expectations as regards what is to be performed. Make sure to have reasonable expectations as regards time and commitment and make sure to agree on what is to be delivered already early in the process. Do it in a clear and sufficiently detailed manner, and in writing. (As regards the value of the performance, senior experts typically have established rates and it will hence be less of a challenge for most.)

7. Restrictions. Shareholders’ agreements may provide for non-compete undertakings and other restrictions for the shareholders. It may however be difficult to get a third party expert to agree to these – prepare to be flexible, and see what works in each case.

8. And a general; Be sure that you, when offering (or receiving) sweat equity, consider the overall terms and have a sit-down to go through the mutual commitments in advance so that there are no disagreements or surprises when it comes to e.g. quantum or conditions when the equity has been issued and the expert is already on the cap table/or the VAT is due. Also make sure to agree on the timing of the valuation – if it is a long-term project the valuation can have shifted when you are ready to invoice.

Conclusion?

If you share you get more. Alignment of interests is a positive, and if used in the right way with clear terms for both parties then sweat equity can be a key facilitator for getting the right team to create success and long-term value.

Katarina Strandberg
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