Why Sweat Equity Often Stinks

Somebody asked for standard boilerplate for sweat equity via the ask-me page on my website.

I am looking for a contract template which states an agreement for services in exchange for equity. I was hoping that you would have a template that you can share.

That’s not going to happen. Fundamental¬†sweat equity is beautifully, blisteringly clear, and real. And needs no template or contract. And most other sweat equity is full of potential problems, misunderstandings, and disappointments.

Real sweat equity

Real sweat equity is solid. It doesn’t take documentation; it’s as basic as walking forward. You start your company, create something from nothing, grow it, and the sweat equity value is simple and obvious. For every company owned by its founder(s), sweat equity is a simple formula

valuation
-  compensation taken
—————————————————-
sweat equity

This is the way of the startup world, for the most part. Real life. Be careful, though, as you develop the business, not to underestimate real expenses and overstate profits by ignoring the fair value of the founder’s work. That messes up the analysis.¬†

When I read business plans as a potential investor, I expect the founders to include the value of their work in the valuation. I don’t like it when they promise to work for less than fair value in the future, because that puts pressure on the system. Sometimes those sacrifices blow up on the company at bad moments. I like a business that can afford to pay everybody working there, including founders. And if the numbers work, the future prospects are good, then that can be part of what investment funds are used for.

And I hate seeing liabilities on the balance sheet (see point 3, below) that track back to unpaid compensation for founders. Your valuation is your compensation.

Everything else

However, a lot of so-called sweat equity isn’t solid; it’s like folded paper, easy to rip or crush, not reliable. Some examples:

  1. Peanuts-and-promises sweat equity: Ralph hires Mary for a lot less than she’d be worth on the market, and a lot less than what it would cost him to get a market-value employee to do what Mary does. Time passes. Mary works. She thinks she owns 50% of the business. But nothing is written. The business takes off. Mary wants her share but now she’s asking, as a supplicant. Her share is whatever Ralph decides is fair. Ugly, but it happens a lot.
  2. Salary-plus-shares sweat equity: This is way better than the peanuts and promises. There’s a formula and some specific numbers to it. Both sides negotiate the mix between money and shares. However, shares are just one number in a calculation that depends on two numbers; percent ownership is another simple formula:

    shares/total shares outstanding = ownership%

    Way too often people dangle shares as reward, without specifying total shares outstanding. It becomes another misunderstanding and disappointment waiting to happen.

  3. Temporary-and-will-be-capitalized sweat equity: Founders work for less than fair value and record the difference between actual pay and fair value as owed to founders, a liability on the balance sheet. This has the advantage of recording real expenses into the financials, so I like it. But founders asking for outside investment should expect to capitalize that and swallow the liability. You can’t use founders’ labor to justify the valuation ask, and then turn around and get it paid too. You know: cakes and eating?
  4. Plain exploitative BS sweat equity: It happens all the time. Whenever startup founders just get together and start working, without really agreeing on who owns how much, and who does what for how much, there’s a 90% or more chance somebody is going to end up shafted, feeling they’ve contributed more than their share and got less than their share back. I hate hearing about this. “You’re an owner” and “we’re partners” and “sure, I’ll take care of you” are incredibly powerful lures used way too often to get more work for less ownership and less money.

 

 

 

Tim Berry , Founder, Palo Alto Software
March 6th, 2013