What is sweat equity, and how can it benefit startups and employees?

It’s a tale as old as time. A startup founder has an idea and, over the course of many sleepless nights, early mornings and missed holidays, they pour blood, sweat and tears into bringing their startup dream to life. 

This is a familiar story for many New Zealand startup founders and early-stage employees who lovingly pour their everything into a business, hoping to catch a break. Below we shed light on how sweat equity can play a key part in equity ownership, employee incentives, and wealth creation to help a company succeed. 

What is ‘sweat equity’?

According to LegalVision, “sweat equity is an arrangement startup businesses can use to help fund their business operations.” While sweat equity can refer to physical labour, it can also refer to services carried out, the mental effort, skills and time spent helping grow a business. 

In an early-stage start-up business, this could look like start-up founders and early-stage employees being compensated for their hard work with a lower-than-market-value salary (or no salary at all) for a set period of time in return for equity in the company. This sweat equity typically ‘vests’ for a three to four-year timeframe while the employee is employed by the business. Once the vesting period is reached or key performance milestones are met, the employee secures equity in the business. For non-founder employees this arrangement enables employees to own an early stake in a rising startup company, with the potential for high financial returns if the company succeeds and is acquired privately or goes public. 

What part does sweat equity play in a company’s growth? 

The sweat equity that employees and advisors can bring to an early-stage business is invaluable. It is a cost-effective way for early-stage companies to attract, incentivise and retain top talent. 

What to be aware of when receiving sweat equity

There are several considerations that both employees and advisors should be aware of when considering sweat equity. 

1. Loss of value: The greatest risk when working for sweat equity in a start-up is that the final value of equity in the company may be less than the time and effort put in. If the company fails, this could make the ‘equity’ in the business worthless.

2. Liquidity: Another key consideration for a sweat equity employee is the liquidity of their equity/shares. Until a company matures, raising capital from institution-type investors or goes public, it may be difficult for the employee to sell their equity in the business via a secondary transaction. 

3. Short-term finances: Earning a below-market salary in exchange for sweat equity can significantly impact an employee’s short-term personal finances. Before entering into a sweat equity agreement, we encourage you to talk to a financial advisor to determine how this will affect your personal financial goals. 

4. Legal: Before entering into a sweat equity agreement, consult a financial and legal advisor. They can review the documents with you and ensure that you fully understand the agreement, including what happens if you leave the business

5. Tax: Depending on several factors, employees are likely to have to pay income tax on the proceeds from the future sale of shares. Make sure you understand what future tax obligations may be before jumping into a sweat equity agreement.

The benefits of sweat equity

There are multiple benefits to having sweat equity in a company. Not only is it a great way for companies to reward early-stage employees or advisors, but it also provides them with the opportunity to be part of a fast-growing sector with the potential for higher mid-term financial returns. 

Sectors such as software as a service (Saas) are projected to grow significantly over the next few years. Globally, Saas is forecast to grow from US$3 trillion to US$10 trillion by 2030. While locally, New Zealand’s Saas market accounts for about 0.1% of the total market with reports estimating it could be worth nearly NZ$14 billion by 2023. For employees, sweat equity in sectors such as Saas provides them with a low-cost, low-barrier entry into a fast-growing sector. 

In addition to investment exposure, sweat equity can provide an employee with mid-term financial benefits when the company is eventually sold, raises capital, or goes public. An example of a strong sweat equity return on investment is New Zealand business Vend, a cloud-based point-of-sale and retail management software company that was founded in 2010. Vend went on to sell to Canadian company Lightspeed for US$350 million in 2021, resulting in a strong return on investment for shareholders, which included many employees.

Sweat equity from a company’s perspective

Sweat equity is a powerful, cost-effective and flexible incentive tool that can play a major part in a start-up's early success. Offering sweat equity can be a smart way for companies to reduce cash burn during the early years of a business while also helping incentivise and retain key talent. After all, if an employee has skin in the game, so to speak, they are far more likely to stay loyal to the company. Aligning key staff with investors can also be attractive to future investors if the company chooses to raise capital at a later date. 

Managing sweat equity doesn’t have to be complicated for companies. Orchestra helps companies and employees actively track their equity and cap tables in real time. Orchestra’s simple-to-use platform allows employees to track vesting, exercise options and model their net worth over a period of time. For companies, Orchestra is a secure platform where their share registry, financial data and investor communications are securely safeguarded.  

There are several factors that companies and sweat equity employees should consider and discuss before entering into an agreement. These include: 

• Voting rights: Whether the sweat equity employees will have the right to vote at shareholder meetings
• Dividends: The right to dividends should also be discussed
• Tax: Finally, a company should also be aware of its obligations to pay PAYE tax on sweat equity employees’ equity. 

Learn more about how Orchestra can help you take control of your equity here. 

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