Ade has been bootstrapping his Startup for about a year now and has seen the business develop the potential that he always felt it had. However, he identifies a need to hire one or two experienced hands that can help take the business to the next level. He realizes that he needs to pay these guys an attractive salary if they are to work for him. Unfortunately, the business can’t generate enough revenue to pay the salaries they demand and he also doesn’t have enough working capital left to afford such a cost. His financial adviser suggests that he offers a hybrid of cash and equity with the latter packaged as sweat shares. Ade has never heard of sweat shares before and is interested in learning how it works.
What is Sweat Equity?
Sweat Shares are a form of equity given to employees or partners in lieu of cash or any other form of monetary compensation. So rather than pay an intending staff the salary they deserve you can pay them half of it whilst the balance will be represented by an equity compensation. Sweat shares provide a lot of advantages for startups and small businesses and can be a very viable way of attracting good talent. By owning a part of your company, your employees or partners share in the risk and reward associated with ownership of a business.
Give Sweat Equity to people who are committed
As mentioned, Sweat Equity is offered to employees or business partners who you cannot afford to pay a monetary compensation to in exchange for their service. To ensure the right people are offered sweat equity, founders must ensure that the people are firmly committed to the cause. You do not want to offer sweat equity to someone who is not as committed as you are to the business. Does he feel passionate about the business like you do? Does he see the business as his own? Does he make unsolicited sacrifices for the business? If you don’t see any of the above there is no need wasting your equity.
Give Sweat only to someone with the right skill
It is also important that you offer sweat only to people who possess the right set of skills and knowledge about the business that you have. Sweat shares offered to people who are learning on the job or do not bring a unique set of expertise is often not worth the stress. Remember, you are offering the person equity because you recognize the worth of his skill and cannot pay the full value for it in cash.
The vesting period is the timeline set for the employee or beneficiary to earn the sweat. For example, you can offer to pay the employee a part of the salary as cash and the other as sweat for a period of one year. During that period, the employee will be allocated sweat shares at the end of every month until the last month enshrined in the agreement.
Since the equity being offered is in exchange for a service, the shares agreement will have to contain clauses that clearly outline what is required of the person to which shares is being offered. It should also be made clear that a breach of any of the clauses may lead to a forfeiture of the shares that could have been earned for that period. This area is the most critical part of sweat equity agreements and often leads to disputes if the agreement is too ambiguous.
Lock up period
A lock of period is a period where the sweat equity holder is not allowed to sell any of the shares already allocated to him or her. Without a lock of period, a sweat equity holder can just pull off midway into the life-cycle of a project dumping his shares along the way to a third-party at a cheap rate.
How do you value sweat?
Valuing sweat equity is almost as difficult as valuing a startup or a small business. This is because some of these business are yet to generate any profits which they can use to value a company. Despite this snag founders can still rely on other metrics to value startups. You can use a multiple of revenues, profits (if any), subscribers/customer base or investment as a basis. For example you have invested about N2 million since the business started. You can then apply a multiple of 2x to it and say that the business is worth N4m. You could alternatively say that the startup has about 10,000 registered customers who you value at N400 each or N4 million in total. You argue that these customers cost about N500 each to acquire and potentially represent future sales points.
Now that the value of startup has been determined, next up is to determine the employee’s share of the equity. If the person should have been paid a salary of N200,000 monthly but you can only afford N100,000 the balance N100,000 will then be converted into sweat. To account for the risk he is taking in sticking with you, you can add a premium of 20% or something equivalent to a bank lending rate as a risk premium. If the vesting period is for one year, the customer will expect the value of his sweat to be N1,440,00. This comes to about 36% of the Startup.
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