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 beautiful, blisteringly clear, and real. It needs no template or contract. 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

–  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 of 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.

If you and your team are serious about your venture, check out Gust’s Co-founder Equity Split tool to better estimate a fair split of founder equity.

Written by Tim Berry

user Tim Berry

Tim is the founder of Palo Alto Software and, the co-founder of Borland International, and the official business planning coach at 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

Co-founder Equity Split: A New Framework to Objectively Divide Startup Ownership and Get Back to Building a Business

We’ve just released our free Co-founder Equity Split tool. It’ll give you a fair and objective recommendation about how to divide your startup’s ownership, so you and your co-founders will have a sensible, real starting point for this notoriously hard, crucially important conversation.

Many startup founders find themselves lacking clarity and direction when it comes time to divide their

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

Update 2017: To help you understand how your startup will look to investors according to this methodology, we’ve created a fundraising feedback tool that will give you investor-level insight into your startup’s performance. In just about 15 minutes, it will tell you how much money your startup is likely to raise, where you can find that capital, and what to

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 >

18 Ways to Make Your Financial Model Stand Out to Investors

The median investor looking at your proposal is in her 40s. Her eyes are going, not to mention her brain. I look at a lot of spreadsheets and analytic reports, and way too many are difficult to read and therefore hard to understand.

In an effort to make my life easier, I’ve summarized here the steps that will

Read more >