A Sweat Equity Agreement is an agreement between a business (usually a startup) and someone providing something to that business, usually a consultant who is providing services.
Under a Sweat Equity Agreement, the consultant agrees to provide the services to the business, and rather than being paid in cash, they receive an ownership stake in the business – referred to as ‘equity‘.
What are the key elements to a sweat equity agreement?
A Sweat Equity Agreement needs to cover the following core things:
- What the consultant will provide in the way of services. This should include clear milestones, with due dates. Ideally you should define ‘outcomes’ rather than ‘hours’.
- How much equity the consultant will be paid, including how it will ‘vest‘ over time as the milestones are met.
- How the agreement can be terminated, and what the impact will be on the services provided and the equity granted.
It is important not to overlook the usual terms that would be included in a ‘services agreement’, for example, the clear assignment of IP from the consultant to the business, confidentiality undertakings, insurance, etc. We recommend that this be clearly recorded in a separate services agreement. Many startups overlook this aspect, and are left with a legal obligation to issue equity, without having received much of value in return.
Equally important is the fact that when you enter a Sweat Equity Agreement you are not just providing or receiving services: the consultant is making an investment, and the business is taking on a shareholder. These transactions are complex in themselves.
When a business takes on shareholders it needs to clearly set out how this will work – the rights and responsibilities of all parties. This is done in either a Shareholders Agreement or a tailored Constitution. It is absolutely critical that a business has this in place before agreeing to issue equity to a consultant (or in fact to anyone!).
Why would someone agree to work for equity?
Cash is King! – So why would a consultant be happy to work for equity?
There are usually a couple of reasons – and they require the needs and desires of both the business and the consultant to line up.
- First, the consultant needs to believe that the business they are working for is likely to be very valuable in the future. This is because the consultant is effectively making an investment in the business.
- Secondly, the business must either not have the cash to pay for the consultant, or it must believe the equity it is giving the consultant is worth less than the value of the ‘scarce cash’ it does have on hand.
Unfortunately, in many cases, both the consultant and the business do not consider these factors seriously enough.
Why a consultant needs to think carefully before accepting equity
A consultant starting out in their own business may think it is better to receive equity in a client, rather than not have a client at all. In contrast, you find that high-quality and in-demand consultants are much more reluctant to accept equity in a client – unless of course they truly believe in the client’s business (and this is rare).
A consultant should only agree to work for equity if they truly believe in the concept being pursued by the startup, and also that the amount of equity properly reflects the value of their services, as well as a premium for the ‘risk’ of the investment they are making.
Why a startup needs to think carefully before issuing equity
On the other hand, a startup may think that issuing equity to a consultant is a ‘cheap’ way to get services. This is wrong. Any corporate finance professional will tell you that issuing equity is the most expensive form of funding to any business. The business is literally ‘selling off’ the benefit of its future profits to save some cash now.
A startup should only issue equity if it truly believes the services of the consultant are worth the very high price being paid. This is usually only justified for founders, and key people who bring rare talents to the startup. In all other cases it is likely to make more sense to raise cash from investors and then pay your consultants with that cash. A professional investor is more likely to be able to properly assess (and therefore truly value) the opportunity presented by the startup.
In so many cases we see startups that have issued equity to consultants and very much regret it. This is particularly so when the consultant negotiates things like ‘anti-dilution’ rights…
What are some of the potential pitfalls to avoid?
Hopefully you are getting the idea that issuing equity to consultants is not a simple thing, and can seriously derail your startup if you get it wrong. If you are still keen, then you must also consider the following additional things:
Employment law considerations
If the person you are issuing equity to is genuinely an ‘independent consultant’, then this will not be a concern. However, if you are dealing with an individual (and not a company) then there is a real risk they may be considered an employee and not an independent consultant. This is particularly so if they are spending a lot of time working with you, and are ‘integrated’ into your business.
A business owes a number of duties and obligations to all employees, including paying a minimum level of remuneration. A Sweat Equity Agreement may be seen as an underpayment of wages, or even no wages at all! An employer who underpays wages can be subject to potentially serious penalties. An employer also has obligations to withhold and remit PAYG tax, contribute a statutory amount of super, honour leave entitlements and comply with unfair dismal and redundancy laws.
The take-away – have you considered the potential application of our complex employment laws to your sweat equity arrangement?
Tax law consideration
This is perhaps the biggest obstacle to get over when it comes to Sweat Equity Agreements. Most of these risks lie with the consultant, but they can also impact the business.
The problem arises because the Tax Office sees two transactions:
- The first transaction being the provision of services by the consultant and the receipt of taxable remuneration; and
- The second transaction being an investment by the consultant of the remuneration received into equity in the business.
Our tax laws do not distinguish between cash and ‘in-kind’ earnings. If you receive equity in return for your services, you are obliged to pay a full rate of tax on those earnings, as if you had received that value in cash, even if you have agreed to invest it in your client.
In an employer-employee context, the employer still has obligations to withhold and remit tax instalments on the ‘non-cash’ remuneration – and in some circumstances may be liable to Fringe Benefits Tax (FBT).
In a business-consultant context, the consultant must recognise taxable income on the market value of the equity they receive. If the equity cannot be valued, then the Tax Office will look to the ‘value of the services provided’ to assess the tax.
In the case of a very ‘early-stage’ startup, it is easier to argue that the values involved are not material. However, if the startup has raised other funding, and therefore has a ‘market value’ for its equity, then these tax issues becomes much harder to manage.
Is it all bad news?
The reason you don’t hear too much about the complexities and potential pitfalls of Sweat Equity Agreements is because most startups that use them fail. This can be a hard truth to accept, but it is the reality.
Those startups that do succeed come to understand these issues very clearly, often paying considerable tax and restructuring costs to clean up their structures.
So, unfortunately, in Australia a lot of the news about Sweat Equity is not great.
What can be done?
For new enterprises we recommend an ‘Equity Deed‘ arrangement, whereby the co-founders are each granted equity up-front in the company, and only get to keep it if they meet a number of milestones over time. If they leave early, then a portion of their equity is ‘clawed back’ to reduce their holding down to something that reflects their actual contributions. This only works when the company is relatively new, and no real material value has yet accrued. It does not work for people who are brought into the structure down the track.
For early stage startups we also recommend adopting a ‘dynamic equity split‘ type concept known as ‘Slicing Pie‘. The benefit of this concept is that a fixed value is not placed on the various contributions of the co-founders. It relies heavily on ‘relative value’ up to the point in time when third-party investor equity is raised. It is similar to the Equity Deed concept, but leaves the actual granting of equity to a later time, rather than upfront.
For later stage enterprises, we recommend a equity plan that complies with the ATO’s ‘start-up’ concessions to avoid the tax charges. To qualify for these concessions the company needs to be less than 10 years old and have less than $50m in turnover. Some major restrictions to the concessions is that they only apply to ordinary shares, there is a limit on the ‘discount’ that can be given to market value, and the person receiving the equity cannot hold more than 10% of the company (in total). This means that it does not usually suit co-founders.
In most other cases the tax hurdles remain and must be dealt with. This is well recognised among the professional startup scene.
How we can help
Over the past 20 years we have helped thousands of startups put in place appropriate equity arrangements to attract and retain great talent to build their enterprises.
For a no-obligation chat about how we can help you, call 1300 654 590.