In the start up of a business, it’s common for some people to contribute money and others to contribute time and effort with “an understanding” that they will share in the future success of the business. Sometimes “equity earn-ins” are used as a way for employees to earn an ownership percentage by forgoing some compensation.
Sweat equity has elements of both “ownership” and “compensation” – which are related but distinct concepts that frequently get mixed together.
Ownership means owning a portion of the stock of a corporation or a percentage of the membership of a limited liability company (LLC). Ownership can be defined in many ways – such as voting and non-voting. Owners expect to share in the future success of the business. For “sweat equity” or “earn-in” situations, LLCs provide more flexibility than corporate structures. The rights and responsibilities of owners need to be clearly defined in a written agreement.
Compensation is payment for services performed and should be designed to reward the behaviors that make the business successful. Compensation plans can be designed to include incentives, such as bonuses and profit sharing. Equity (ownership) can be an element of an incentive compensation plan.
Sweat equity for “employees”
Sweat equity for “employees” is usually compensation for “below-market wages” for services performed. In this case, you can calculate the value of the sweat equity based on market rates.
First you determine the market rate: How much would you pay an engineer to design a prototype? How much would you pay a market research professional to conduct a survey?
The difference between current compensation and market rate compensation gives you the uncompensated “sweat.” With this information, you can quantify the amount of sweat equity – but that’s only part of it! Then you have to decide how it will be compensated – through deferred compensation, profit sharing, percentage of ownership, or a combination of methods.
Sweat equity for “partners”
Sweat equity for “partners” (owners) is much more complicated to calculate. While it is easy to quantify the dollars invested in the business, contributions of intangibles such as “know how” and customer contacts are more difficult to value. Even more difficult is determining the “value” of individual work efforts in different areas related to developing the business – such as IT, Engineering, Sales or Marketing. Sales milestones are one approach, but that doesn’t work for all situations.
While it sounds nice to say you’re “partners” – and you’ll work things out as you go along – there can be problems! People have selective memories and there can be misunderstandings. What happens if participants stop performing or there is a falling out within the team? You don’t want to find out later that your “partners” had different assumptions.
If you’re considering a sweat equity arrangement -
Whether you’re investing “money” or you’re investing “sweat,” it’s really critical to have a clear written agreement about how the “equity” is earned and what ownership means.
For the best results, “sweat equity” and “earn-in” plans should be carefully crafted to ensure that the goals of the participants are aligned with the goals of the business. The plan needs to include a clear valuation methodology, definition of participant responsibilities and restrictions on ownership transfer and buy-back provisions.
In conclusion, “sweat equity” and “earn-ins” can be a great way to get a business started and provide incentives to employees. But, in my experience, if the parties can’t get to an agreement early on about how the “sweat” equity will be earned and ownership allocated, it’s a warning of problems ahead.