What is a Sweat Equity Agreement?

What is a Sweat Equity Agreement?

A sweat equity agreement (SEA) is a contract between a business and another party who is performing services for the business. Under a SEA, the other party receives equity in the business opposed to being paid with cash. An SEA is often used by startups.

This article will explain the key considerations to make when entering into an SEA, and the important elements of the agreement.

Key Considerations and Reasons For Using a Sweat Equity Agreement 

Sweat equity is a great way to grow your business. However, before pursuing a SEA, it is important to consider whether the employee or separate entity:

  • is committed to ensuring that the business succeeds;
  • is willing to provide services to your business for the long-term;
  • shares in your business ideology and consistently strives for success; and
  • can increase the value of your business by a reasonable and/or considerable amount.

It is also important to understand the reasons for using a SEA. As previously stated, SEAs are commonly used by startups. This is because startups may not have cash readily available to pay service providers. Here are a few reasons why a start-up may opt for a SEA:

  • It is a good method of attracting talented, bright employees.
  • Ownership of the business can be distributed fairly according to the amount of work each founder performs.
  • Although sweat equity is a high risk investment, the potential rewards are just as high. This is attractive to risk-taking employees, investors and consultants.

What to Include in a Sweat Equity Agreement

It is important that one does not sign over their entire business to the service provider. With that being said, a SEA must be drafted carefully, and the key elements must be understood by both parties. Thus, here are a few elements that you should be aware of:

  • Type of equity: There are several different types of equity. Identifying the type of equity that the other party will receive will create transparency.   
  • How much can be earned: The amount of equity that can be earned should be capped. Generally, the larger the business, the lower the cap.
  • Rate of accrual: The rate at which the other party’s equity will accrue must be established. For example, an employee who earns $40,000 per year, can be paid that in equity at the year’s end. 
  • Performance and work rates: It is important to clarify performance expectations. In this, the role of the other party, and what is expected from them, must be specified.
  • Vesting periods: A vesting period is a period of time that shares cannot be sold or traded. It is important to note that the other party owns the shares throughout this period. However, their selling rights only activate depending on the quality of their work.

To Sum Up

SEA’s, while complex, can be extremely beneficial for a business – especially a startup. When considering an SEA, it is important that the other party is committed to the business ideology.

If you need any assistance relating to your startup or small business, our commercial lawyers are here to help! Just contact us at 1300 997 337 or fill in the contact form on this page.

About Daniel Katz

Daniel is a legal intern at OpenLegal, placed in our legal content team. He is currently studying a Bachelor of Laws at the University of Technology Sydney. Daniel's interest lies in economics and media/startup law.