Q: What is the best way to negotiate and grant someone “sweat equity” in my startup?
A: Granting sweat equity in exchange for services rendered can be a creative and effective way to ramp up your startup with limited capital. The considerations will vary slightly depending upon which compensation method you use, but include i) the market value of your business, ii) the market value of the contributor’s sweat equity, iii) the risk premium, and iv) how the sweat equity is compensated.
Market Value of Your Business – If the sweat equity is compensated in the form of equity, then both parties need to agree upon the valuation. Most startup businesses with nothing more than a business plan are valued in the $500k to $2m range, but the valuation can certainly be higher or lower, mainly depending upon the company’s location, traction, and management team. Ideally if you’ve raised some capital from angel investors or seed investors, you already have a market-based valuation. The main point is that the market value needs to be discussed and negotiated.
Market Value of the Contributor’s Sweat Equity – In like fashion, both parties need to agree on the market value of the contributing party’s time.
Risk Premium – Once the market values are established, the parties should agree upon the amount of “risk premium” to compensate for the risk of contributing time in exchange for an uncertain future payout. That premium might come in the form of paying more than market for the time, granting the equity at a deeper discount, or a combination of both. The point is to make the amount of the risk premium crystal clear.
Sweat Equity Compensation – Finally, both parties need to agree on how the value will be exchanged. The contributing party might receive cash, stock (which is taxable upon receipt), warrants (which is taxable once exercised), a revenue royalty, other form of compensation, or some combination of any of those.
Example – Let’s say you’ve recently taken on an angel investment that valued the company at $1m post-money with 1m shares total outstanding, you’re hiring an attorney to consult with you for 20 hours whose normal billing rate is $400/hour, and you’ve agreed upon a risk premium of 2x on any at-risk time invested.
- Example Sweat Equity Deal with 50% Cash and 50% Royalty – The attorney gets paid cash of $200 per hour (a total of $4,000) plus a royalty of 5% of Revenue. Since the attorney got 50% of the normal billing rate in cash, there is no need for a risk premium on that amount, but since the attorney is risking $4,000, it is fair to get a risk premium on that portion of time and therefore the royalty amount should be up to $8,000 with a cap of 2x as the agreed upon risk premium. If everything works as planned, the attorney would eventually get paid a total of $12,000 over time ($4,000 upon completing the work and $8,000 in royalty payments).
- Example Sweat Equity Deal with Equity – The attorney should get the negotiated risk premium on all $8,000 of the market value of his work, or $16,000 in equity. That would mean 16,000 shares valued at $1/share, or alternatively, you might issue a warrant for 16,000 shares at $1/share (if you are more sensitive to share price) or a warrant for 8,000 shares at $0.50/share (if you are more sensitive about the number of outstanding shares).
Other Key Points on Sweat Equity:
- Be sure to memorialize the agreement in writing to avoid any miscommunication
- Be sure to get good tax and legal counsel to understand all of the consequences of the deal
- Be sure to strive for fairness since the agreement should present a good and fair opportunity to both parties