Sweat Equity – The Dangers of Giving up Too Much Equity Too Soon
Sweat Equity – The Dangers of Giving up Too Much Equity Too Soon
8th June 2023
Every investable entrepreneur knows that equity isn’t just monetary, it’s also the hard work, time, dedication, and “sweat” that you and your stakeholders have put into your company to make it happen and increase its value.
This “sweat equity” is your most precious commodity. If you give too much of it away too early you’re guaranteed to regret it later.
Sweat equity is the non-monetary contribution that founders and stakeholders put into a startup to get it off the ground, keep it going, and make it successful. For most cash-strapped startup founders, it’s the only way they’ll initially be able to fund their company. Sweat equity also doesn’t stop once the first investment has been secured. Even after that investor comes onboard, most founders and their early-stage employees will continue to accept a salary that’s below market value in return for a stake or shares in the startup that they’ll hope to profit from when the startup is sold.
The biggest danger of sweat equity is, how much should you give away? We’ve known a lot of founders who have ended up exiting their startup with very little return because they handed out far too much equity in the early days. That’s because starting up a new business, especially for a first-time founder, also comes with an intense feeling of vulnerability. Most startup founders are so focused on doing what they have to do to make their business a reality that it can be very difficult for them to realise when they’re giving too much of their equity away too early.
In our experience, it’s not just pre-seed or early seed founders who make this mistake. We’ve even had clients raising Series A rounds who have admitted they’re angry with themselves for giving away too much of their equity too soon. Their fear is that, by having done so, they’ll eventually see very little financial reward for their efforts once their business is fully funded and profitable.
This can also hinder a founder’s ability to raise future investment. A consideration for many later stage investors will be whether or not the founders are ‘over diluted’, or in simple terms, whether they have enough equity left to make continuing the venture worth their while. This is a real risk for investors, as over diluted founders are likely to be distracted by new opportunities and ventures where they can start again without making the same mistakes and retain more of the equity.
So, our advice is to think very carefully about what you ‘spend’ your equity on and try and part with as little as possible. A good benchmark is to reserve a maximum of 5% for sweat equity deals with advisors, and 10% for sweat equity deals with your first employees.
What should sweat equity be used for?
In our opinion, equity should only be used for four reasons:
Bringing co-founders on board.
Bringing strategic advisors on board as part of an official advisory board.
Creating a share options scheme for the earliest employees.
What should sweat equity not be used for?
Equity should NEVER be traded off for ‘one-off’ services provided by agencies and freelancers, i.e., product development, branding, and marketing.
Sweat equity: The founders short-term view vs. the investors long-term perspective
The problem is too many founders think short-term. They trade equity to access resources they need that they can’t currently afford, without thinking about the repercussions that may have on the future.
Investors, on the other hand, always look at business with a long-term view. Before they make the decision to invest in you, as part of their due-diligence, they’ll run a fine-tooth comb through your cap-table to see who has a stake in your company and why. If they see you’ve offered any of your stakeholder’s equity for the wrong reasons, it’s very likely going to raise a red flag and stop the deal in its tracks.
That’s not just because you’ve given away sweat equity for what the investor considers to be the wrong reasons, but because the investor knows that you’ll inevitably be diluted even further throughout your journey as you raise subsequent rounds of funding, bring on more advisors, and recruit your first employees.
They’ll know from experience that it can be a huge disincentive for a founder when they give too much sweat equity away. That’s because, when the founder realises they’ve diluted themselves so heavily that they won’t see a satisfactory return on all the effort they’ve put into making the startup successful, they’ll probably decide to abandon the venture and turn their attentions elsewhere, most likely towards building a new startup without making the same mistakes.
No investor will be prepared to take that risk. Before they’ll put their money into your business, they’ll want to be certain that you’ll always own enough equity in your business to make it worthwhile and keep you incentivised. If you don’t, any prospective investor will quickly back off.
How to calculate sweat equity
Most startups determine their company value based on equity capital, i.e., if an investor invests £2m for a 20% equity stake, the startup would be worth £10m (post-investment).
A similar process is often used to calculate sweat equity, however for pre-funded startups it’s often too early in their journey to determine a reliable valuation, and it’s usually the first funding round the sets the market value of the start. So how do you calculate sweat equity ahead of a funding round?
There are typically two approaches:
You quantify the value being traded for equity (i.e £200k of advisory services provided over a 3-5 year period) and base the sweat equity agreement on the target valuation for your next funding round
You come to a sensible agreement with the other party as to what is realistic, considering the factors mentioned above such as not wanting to become over diluted, and reserving some equity for your first team members.
But always remember, the more sweat equity a founder gives away, the less returns they’ll receive when their startup sells in the future. So be certain you won’t regret your decision before agreeing any deal.
What is a sweat equity agreement?
As a founder you should always establish a sweat equity agreement to ensure that everyone involved adheres to their commitments.
A sweat equity agreement is a legal document between the founder(s) and all the other parties who are earning sweat equity through the business. It’s important to draw up a sweat equity agreement during the beginning stages of the startup to avoid any conflict.
What should a sweat equity agreement include?
The sweat equity agreement should include:
the ‘vesting period’ for founders and early-stage employees based on their expertise and commitment (‘vesting’ essentially means that the total sweat equity agreed is earned based on certain agreed milestones being achieved)
the type of equity, based on the party’s skills and their value-add to the business.
the performance criteria (i.e., clarifying job expectations)
the separation criteria, including a fair exit plan, for when the startup is sold or if any of the parties leave the business early.
When should I give away sweat equity?
Think long-term. Every percent you give away today is one less percent you’ll have to leverage in the future, either for millions in funding, or contributing to your own personal returns at exit. That’s especially true if you’re considering offering sweat equity in return for products or services. If that is what you’re considering, our advice would be… don’t do it.
The road of a startup founder is already hazardous enough. Never run the risk of disincentivising yourself later in the journey by trading too much of your sweat equity too soon.
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