Sweat equity is created when you or others contribute work to a business in the hopes that it will pay off in terms of an interest in the company as opposed to hourly or salaried wages.
You may hear a web designer saying that they took a 2% interest in a company that they paid for in sweat equity. They traded the value of their time for a stake in the company.
Trading time for equity is a time-honored tradition among startup companies and is used very aggressively. While at first it may seem like you’ve printed a whole bunch of Monopoly money that you can start using to pay people with, you’ll soon find out that there is a real cost to offering up stock early on.
With sweat equity, it is critical that you translate effort into dollars so you are comparing apples to apples.
For example, if you are looking to bring on a web designer to build your website and would like to pay them in equity, you will want to spell that out in a specific dollar amount. While you may pay a premium given the risk they are taking, you don’t want to give away a big chunk of your company for a $5,000 contribution.
The challenge to trading time for equity is valuing the contribution. There are two levers at work: the total value of the company and the value of someone’s contribution. Valuing someone’s contribution is relatively easy. Most people have a market equivalent cash rate for their contribution.
The other factor then is the value of the company. Unfortunately there is no Kelley Blue Book of a company at any given point in time. That value is ultimately determined by what investors are willing to pay for the stock, which can fluctuate wildly and often without any sensibility.
That said, you have to start somewhere. If you were to place an arbitrary value on the company of $1,000,000, then someone who would otherwise make $50,000 per year in cash, if working for your company for one year would earn 5% in stock. Often that amount is increased by some percentage to account for the fact that this is stock with a lot of risk, versus cash which has none.
Sweat equity has many benefits but it can also be over-used. Let’s face it: people need to pay their bills, and the possibility of incredible future wealth will only motivate people for so long.
The pros are obvious: you get access to resources without having the cash in hand to pay for them.
The cons on the other hand are less obvious. In the early stages of your company it’s easy to hand out equity because you own 100% of it and it feels “free.” It’s not. Once you’ve started to dilute the pie it’s very difficult to regain that equity. That means you’re spending out of an account that can’t easily be recharged.
Giving out 10% of the company to someone willing to help build your initial prototype may sound like a great idea when you have nothing to lose. But as time progresses, you’ll often find that the resources you need to get started were incredibly expensive compared to what you need as you grow.
You may not need to look very far to find people or companies willing to work for a combination of cash and equity compensation. If you are looking for people willing to work strictly for equity, that will be more challenging.
The best place to find people willing to do this is to network with others who are already engaged in the startup community. Often times it will be other entrepreneurs or service providers who understand the risks and benefits of startups that will be willing to help you move forward for a share of the future pie.
The best way to communicate the opportunity is to translate effort into the dollar amount of contribution. For example, you may tell a web designer who charges $40 per hour that you will compensate them at a rate of $65 in equity. This helps put their contribution in terms they will understand.
Like anything, you will want to make sure that you detail out how the person is being compensated in writing to make sure you protect yourself and your business. Not doing so can leave a variety of legal loopholes open that you want to avoid.
While you are battling to generate revenue, the last thing you need is someone claiming that you owe them money or that they own a large share of your company. Put everything down in writing and make sure you don’t over promise or over pay. Remember, you will likely be the only original face of the business in five years.
Sweat equity can often cost more than it saves you. If you have access to capital, you will want to offer some type of cash contribution and use equity to entice higher level talent.
There are often times people can afford to work for less but rarely can they work for extended periods for nothing. Don’t rely on hype to carry the ball for you. You will need to call plays and keep a read on your team’s passion and enthusiasm. The energy and culture of a startup can be critical to its success, so weed out concerns early and keep the communication open.