Please note this blog post is written for employers, although we understand it may be of interest to employees as well. At this time, our firm represents business owners and employers. If you need assistance with a legal matter as an employee, please consult a firm that represents employees.
Not all contributions to a business are financial. For example, John and Jill might form a business. John contributes $50,000 but Jill does all the work.
After two years, the business is now worth $150,000, a three-fold increase in value—all thanks to the sweat of Jill’s brow.
Sweat equity is the increase in a business’ value thanks to hard work. If you don’t have the funds to contribute to a business, you can contribute in other ways. But you will want a legal document that protects your right to equity.
The Difference Between Sweat Equity and Labor
Anyone who works for a business contributes to its value (unless they are terrible at their job). For this reason, a company’s employees might increase the equity of the business. But you don’t need a sweat equity agreement for your employees for one simple reason—they aren’t owners and you don’t intend to make them owners.
That’s where the “equity” portion of sweat equity comes in. The term refers to an ownership stake in the business, and a sweat equity agreement is only necessary if you want to grant an ownership stake to someone who doesn’t have capital to buy their way in.
When You Need a Sweat Equity Agreement
If you are forming a partnership, then you probably need a sweat equity agreement. A partnership is an agreement between at least two people to run a venture jointly. Partnerships bind each partner to each other and make them personally liable for business debts.
When you form a partnership, each partner brings something to the arrangement, usually start-up capital as well as their labor. You need a written sweat equity agreement in this situation.
You might also need a sweat equity agreement if you are forming a different business structure with someone who wants to earn equity by working. This person might not have any capital to contribute or they have some but want to own more equity than they can buy.
If you are unsure about whether you need a sweat equity agreement, meet with an attorney to discuss your case. You need to get these documents nailed down before starting your business, so schedule a consultation.
What Goes into a Sweat Equity Agreement?
You need an equity agreement that is clear and is written with future contingencies in mind. Generally, an equity agreement should contain the following:
- The total amount of equity that may be earned. For example, you might want to limit it to 50% if you have a two-person partnership. Larger companies often set the limit much lower. You might also want to set a minimum amount.
- The rate at which equity accrues. One option is to use the person’s salary or rate of pay to calculate equity. If the person is paid $30,000 a year, then they could have this much equity at the end of the year in lieu of a salary.
- Conversion rates. Will the sweat convert to equity every month? Every two months? Six months? This can matter if the person is gaining voting rights.
- Vesting period. You might not want the person to immediately start gaining equity, especially if they are new to the business. You could set a six-month vesting period during which their labor will be compensated in cash and then, after vesting begins, they begin to earn equity.
- Type of equity. Some companies have different tiers of stock. You should identify the type and the quantity the person is earning.
- Performance criteria. Be very clear about the responsibilities for each partner, which is vital if a partner tackles several roles at once.
You also need a section on separation criteria. Unfortunately, business owners jump around, and you can’t expect someone to stay with the business forever. Sometimes, businesses need to eliminate roles against your wishes. You need to spell out in advance what happens to equity in the event of separation.
These are only some of the items that should be in a sweat equity agreement. There are many other helpful terms, depending on your situation. Work closely with a Florida business lawyer to draft a sweat equity agreement that works for you.
How to Determine the Value of Sweat Equity
A sweat equity agreement is a valuable tool for small businesses to encourage people to join the team and invest in their company.
But it’s crucial to properly determine the value of sweat equity. You use this to enhance the overall valuation of the business. After all, potential investors and partners need to know what their time and money are going toward.
Calculating sweat equity ultimately involves assigning a dollar value to a non-monetary benefit that the company received from the partner. Therefore, effecting an accurate accounting of the person’s equity is important to understand what they are getting for their contributions to the company.
One way to calculate sweat equity is to find out the ownership or equity share that the individual’s contribution represents. You might accomplish this by calculating what the person would have received in monetary compensation if they had been paid for their services. Or you can look at the opposite: What reasonable financial opportunities did they miss out on because they were working for your business without receiving compensation?
You use this base figure to determine what equity percentage the individual holds in the company, after subtracting things like compensation they received or capital they gave to the business.
Why Is Sweat Equity Important?
Sweat equity is vital because it considers the accurate and equitable contributions of the business members. Every small business owner knows it takes more than cash to keep the lights on. Time and services spent on furthering the business venture are worth just as much as a check.
Further, a sweat equity agreement is an equitable way to invite others to contribute to the business. Providing this alternative means of sharing ownership in the company encourages talented management or other players to join in, even if they don’t fork over money at the outset.
Additionally, sweat equity increases the business’s valuation by considering the actual value of the equity holder’s services. These may include time spent managing the company, a team, finances, or any number of aspects of running a business. The company no doubt enjoyed the benefits of these services, and it only makes sense to include those as part of the overall valuation of the business.
A well-drafted sweat equity partnership agreement is essential to ensure that the parties understand what equity rights the person receives. The deal might lay out what the individual is giving to the business and what percentage of equity they receive in return. A business attorney can help you draft and review an appropriate sweat equity contract.
Should You Offer Equity?
You don’t have to offer an ownership stake. Instead, you could make someone an employee and pay a salary or wage. Before deciding to grant someone equity, consider the following:
- How committed is the person to the business? Have they participated enthusiastically in early discussions of the business? If you suspect a person won’t stick around, you might want to forgo giving them equity.
- Can the person truly increase the value of the business? If not, then they are probably replaceable and should probably be an ordinary employee.
- Do you see eye to eye? A business will flounder if owners disagree on fundamental issues, like the immediate direction of the company and the preferred rate of expansion.
Your answers to these questions will also drive the content of your sweat equity agreement. For example, if you are unsure about someone’s passion or commitment, you might have a lengthy vesting period to protect yourself.
Experienced Business Lawyers
If you are forming a business, or if you are taking on a new owner, you should carefully cross all your T’s and dot all your I’s. The proper legal documents can help minimize disputes later, which can save your business time and money.
Contact BrewerLong today. Our Florida business lawyers have drafted or negotiated many sweat equity agreements. We will identify what you hope to accomplish with this agreement and then tailor it to fit your needs. Contact us online today.