I have been asked several times what my opinion is about “sweat equity” in start-ups or early-stage growth businesses. I have also been asked to be part of this type of agreement several times.
I am now going to share with you the pros and cons of this in my opinion, for those on both sides of the coin.
First, for those of you who don’t already know what I mean by “sweat equity” it is where someone works for a company for no salary, but in exchange for their effort and expertise they get a share of the company, some equity.
Next let me make it clear. I am not talking about those people I consider to be the founders of a business. It is very common that those folks, the people who get together and have the idea in the first place, or start to develop it, rarely take a salary from the business at first. For them it’s all sweat and all the equity. I’m talking here about when you as the founders discover the gaps in your experience, knowledge or capability and start to engage more people either on a full time or part time basis. Your first round of employees. When you probably still don’t have enough money to pay salaries.
So as a founder what are the pros of employing people using sweat equity?
First of course it doesn’t cost you any cash. We all know how precious cash is to a business. So, having somebody work in the business and not draw a salary but get a piece of the business sounds very attractive. In fact, it should make the individual more committed to help the business grow and become profitable because that is how they get their reward. If you can get people to do this, it’s a “no brainer” isn’t it? After all you will only be giving them a small share of the business and you have lots of it left, don’t you?
Another advantage for you as a founder is that the kind of people who can do this are often financially independent and often have far more experience than you in specific functions of business. Maybe it’s sales and marketing, or manufacturing. At least it should be something that is not your strength or else you wouldn’t be looking for their help, would you?
Truly though, that is where I see the major advantages for you as a founder start to dry up. In the excitement of the start-up and growth phases of your business it can be a quick fix and you forget the issues it can cause, especially if you don’t pay attention to the details of the sweat equity arrangement.
So, let’s talk about the cons of using sweat equity, just what are they?
Well first it is not free. It may feel that way, but it is costing you part of your business. I always advise founders to keep as much of their business as they can in the early stages and only start to trade shares in it when it has a proven value. Business values can grow very quickly in their early years assuming you have some form of success. You will be amazed how much more your business becomes worth when you record your first sales for example. I have lost count of the number of founders who tell me that they feel they have “given away” too much of their business in their early days.
Next. Even if you do find a very useful employee, or perhaps make them a director, who works for sweat equity they do have to survive. If the person does not have an independent source of money, they will at some point need to get paid. At that stage you could lose them or must pay them at least a rudimentary salary. The odds are it is going to take you longer to generate cash from sales in your business than your business plan suggested when you convinced the person to work with you. So be prepared for that.
Another thing to consider is that most people working for sweat equity, either those who have made their fortune already, or those who need to provide for their own needs normally are not going to be working for you and you alone. Most have other interests as well, so you can often find that things take longer to happen than you would like, and for start-ups that can prove terminal
Now I have touched on the subject of losing your sweat equity employee it seems like it will be a good time to mention the details of the sweat equity agreement you didn’t quite get round to formalising with them. They leave your business, and they take their shares in your business with them if there wasn’t something in your agreement that managed this situation. Stop laughing as you read this, I know you would never be that stupid, but I know lots of founders who were.
