Issuing Sweat Equity at Different Stages of a Startup
Q: How much equity do you give a co-founder at different stages of a startup: 1. After creation of a prototype, 2. Creation of initial MVP, 3. Getting an initial set of users, 4. Getting a large set of users, 5. Getting the first paying customers, etc.?
A: First of all, I love the way you are thinking about it, because way too often Sweat Equity is just granted in one big chunk as in the following scenario where irrational enthusiasm leads to over-commitment and poor communication:
Startup Founder: I’ve got a great idea!
Sweat Equity Consultant: I can develop the entire app for you!
Startup Founder: I’ll give you x% of the company!
Both: Let’s just wing it!
The tendency is for each side to over-commit and over-promise with a vague vision, vague goals, and a vague timeline. In addition, everything is poorly documented due to the time and expense to do so properly.
The danger is that Sweat Equity arrangements often don't go well because the work is typically not well defined, often not well delivered, and promises of equity are often not kept, resulting in unmet expectations and a bad business divorce.
I’ve used sweat equity arrangements numerous times when hiring consultants for startups and when advising startups in exchange for sweat equity (typically in the form of warrants), so I’ve lived with the consequences of both granting and receiving sweat equity (and I’ve seen lots of startup horror stories involving contentious ownership fights). I’m also a partner in a venture capital firm that invests in tech startups and from my perspective, it’s critical to issue Sweat Equity correctly to successfully set up the next stage of a startup launch and fly through the venture capital due diligence process.
Nothing will kill a potential VC investment quicker than a sloppy or vague ownership structure without the proper legal documentation and protections.
There are three key concepts to keep in mind regarding Sweat Equity:
Forms of Sweat Equity - The type of Sweat Equity can take on many different forms, from founder’s stock to a stock warrant to a revenue royalty, or even a SAFE (Simple Agreement for Future Equity) or a Convertible Note, both of which convert into Series A preferred shares in a qualifying venture capital round.
Risk Premium - Sweat Equity compensation needs to involve sufficient upside value to offset the risk of trading time for an uncertain future outcome, known as the “risk premium”.
Mix of Compensation - In many cases, a Consultant is contributing effort to a Company will need some amount of cash in order to sustain their living expenses. Therefore, it’s often important to keep Sweat Equity arrangements flexible with a mix of some cash and some risk premium in the form of non-cash Sweat Equity compensation.
Here’s the process I recommend, which is going beyond just different stages, but is based on statements of work with very specific deliverables:
Because of all the issues with Sweat Equity, I ended up collaborating with a number of attorneys over the years to develop sweat equity agreement templates that incorporated all of the necessary terms to protect both the startup founder that issues Sweat Equity, and the startup consultant or advisor that works for sweat equity.
And, as a dyed-in-the-wool entrepreneur, I created a downloadable kit to create iron-clad sweat equity agreements quickly and easily and at a very low price for startups.
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