Thoughts on startups by investors that
fund them & entrepreneurs that run them

Why Sweat Equity Often Stinks

Posted by on March 6th, 2013

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.

 

 

 

Written by Tim Berry

user Tim Berry

Tim is the founder of Palo Alto Software and bplans.com, the co-founder of Borland International, and the official business planning coach at Entrepreneur.com. He has been called the "Obi-wan Kenobe of business planning" and "The Father of Business Planning." He is a serial author of books and software on business planning.

prev next

You might also be interested in

Gust Launches Comprehensive Equity Management Platform for Cap Table Management and 409A Valuations

Gust announces acquisitions of Sharewave and Preferred Return; creates the most robust and affordable equity management solution for early-stage startups.

June 22, 2016 – NEW YORK, NY –  Gust, the global service provider powering the entrepreneurial ecosystem, announced today the launch of a comprehensive equity management platform, Gust Equity Management. The new platform provides early-stage companies with powerful

Read more >

From Accelerators to Venture Capital: What is best for your startup?

With startup growth up 61% since 2014 and more investment programs emerging, it can be overwhelming for founders to know just where to jump in. As the most startup-friendly accelerator on the planet, MassChallenge has helped 835 startup companies around the world, who have raised over $1.1 billion in funding and created over 6,500 jobs. We have seen startups at

Read more >

Valuation Part I: Peeling the Onion, or How Top Investors Value the Startups They Invest In

Early-stage technology company valuations are generally a crap-shoot. Bill Payne did a great post about this in October 2011. This post builds on top of his work, and attempts to shed additional light on the valuation process.

New founders may think that startup valuations work like this:

I figure out what the value of my existing company is I figure

Read more >

Starting a startup as CTO / Head of Product

After less than a year, Glassbreakers is now a team of 10, we have thousands of active users on our free product, we’ve expanded into enterprises with paying customers and raised over a million in seed funding. After a few of my Glassbreaker matches inquired, I started to reflect on what it’s like to build a startup

Read more >

Raising Capital As A First Time Founder

A year ago, in mid September 2014, I walked out of a Starbucks in San Francisco with the very first check from an angel investor for Glassbreakers. Though it was only $5,000, it was enough to prove to myself and my co-founder, Lauren Mosenthal, that we could actually fundraise for our startup. We already had 1,000 women signed

Read more >

Comments