As a startup founder, you’re often balancing tight budgets against the challenge of retaining your key team members or co-founders. This is especially true if you’re in a high-growth or pre-revenue business: how do you keep your staff onboard?
Many startups tackle this by setting up Sweat Equity Agreements. But what does this actually mean, and how does it work legally?
What Is A Sweat Equity Agreement?
A Sweat Equity Agreement is a contract under which an employee or contractor receives equity in exchange for providing services to a business. This means that instead of getting paid in cash for their work, they are given shares in the company.
When Do You Use A Sweat Equity Agreement?
Sweat Equity Agreements are normally used by startups so that they can engage workers even though they can’t afford to pay them. In particular, it’s a common arrangement with software developers in a tech startup.
Workers will usually accept this “sweat equity” if they believe the value of the company will grow in the future to a level that compensates them for their time and efforts. That’s why it works better for startups with a potential for high growth. For the workers, it’s often a case of high risk, high reward.
What’s In A Sweat Equity Agreement?
A Sweat Equity Agreement typically includes clauses setting out:
- How much equity will be granted to the worker
- Milestones: Any milestones that are involved in the equity being granted. For example, it may be specified that the worker must complete development of a particular system before they are granted equity
- Services: The services that must be provided by the worker in order to receive the equity
- Termination: Clauses that govern how either party can exit the contract
Sometimes startups will include “vesting” provisions in their Sweat Equity Agreement. Vesting means the company provides potential shareholders with shares that are issued on an incremental basis, over a period of time or upon achieving certain milestones.
These provisions incentivise the worker to stay with the business for longer or complete specified services. This provides security to the startup that the worker won’t just take the equity and not deliver the agreed services.
Are There Legal Risks To Consider?
Sweat Equity Agreements sound like a simple solution for startups, but there are a number of legal considerations to take into account.
Firstly, it’s important to remember your obligations under employment law. In particular, there can be minimum wage issues with Sweat Equity Agreements if they are not properly implemented.
You could be breaking the law by essentially paying an employee £0 per hour!
It’s best to speak to a lawyer before you put this kind of agreement in place so you can avoid being liable for salaries and superannuation payments down the track.
Another consideration is your business structure.
Sweat Equity Agreements only work if you have a company structure in place. They can’t be used for sole trader or partnership structures, as there is no equity to give!
A Shareholders Agreement is a contract between the company and its shareholders (all the people who own shares in the company).
If a worker is signing up to a Sweat Equity Agreement, they may need to sign the business’ Shareholders Agreement, too. If you don’t have a Shareholders Agreement in place, it’s a good idea to set one up before granting sweat equity.
The Shareholders Agreement puts in place additional rights and obligations for shareholders, covering things like:
- How many shareholders will there be?
- What proportion of shares is owned by each of the shareholders?
- What is the relationship between the directors and the shareholders?
- How will disputes be dealt with?
- What happens if a shareholder wants to leave?
Need Help With A Sweat Equity Agreement?
Putting together a Sweat Equity Agreement gives your startup the opportunity to work with top talent when your cash flow is low, but it’s a complex legal document that’s essential to get right. It’s a good idea to invest in a lawyer to assist you with this process, as this one-off cost can help prevent disputes, misunderstandings and save you from problems in the long run.
At Sprintlaw, we have a team of experienced lawyers who can assist with your Sweat Equity Agreement and other legals your business may need help with. Get in contact with one of our consultants for a no-obligation chat about how we can help.
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