Sweat equity - shares or options?

What is Sweat Equity?

Sweat equity is commonly used by start-ups where employees, consultants or other service providers agree to receive shares in the business instead of, or as part of, their cash remuneration.

For an early-stage business, paying in equity can preserve cash that would otherwise be needed to pay wages or fees.

Sweat equity can also incentivise people working in the business by giving them a stake in its future success and aligning their interests with the company’s objectives. These may include an eventual sale or listing, when shareholders may be able to realise the value of their shares.

In the UK and elsewhere, sweat equity can help businesses attract and retain talent when cash resources are limited.

Are there different types of sweat equity?

Yes. The appropriate structure depends on the company’s objectives and the recipient’s role. The main options are to issue or transfer shares or to grant share options.

Equity shares

If you want an employee or service provider to become a shareholder immediately, existing shareholders can transfer some of their shares or the company can allot new shares. An allotment of new shares dilutes existing shareholders’ percentage ownership unless they participate in the allotment.

Where shares are acquired by a director or employee by reason of their employment, they will generally be treated as employment-related securities. Income Tax may therefore arise on acquisition, based on the relevant taxable value of the shares. This can be manageable where a start-up has a low valuation, but the tax cost may be more significant if the company has already built up value.

One option may be to issue growth shares. These shares are designed to participate in future growth above a specified threshold and may therefore have a lower initial value. Their valuation and tax treatment should be assessed carefully before they are issued.

Key considerations with Sweat Equity Shares

• Ownership and dilution – A share dilution table can help show how equity will be distributed between existing and future shareholders, including the effect of planned investment rounds and employee incentives.
• Shareholder rights – Depending on the rights attached to the shares, recipients may be entitled to vote, attend meetings and receive dividends. Different share classes can provide different rights.
• Shareholders’ agreement – Consider what happens when a recipient leaves, including whether they must transfer their shares, how the shares will be valued and who can acquire them. These provisions should be considered alongside the company’s articles of association.
• Tax reporting and elections – Employment-related securities can trigger reporting obligations and, where appropriate, elections such as a section 431 election. The applicable requirements and deadlines should be checked for each arrangement.
• Purchase price and commitment – Requiring a recipient to pay for shares may help demonstrate their commitment to the business. However, the price and terms should be determined with regard to valuation, company law and the relevant tax consequences.
• Recovering shares – Once shares have been transferred or issued, the company cannot simply reclaim them. Any compulsory transfer or leaver provisions should be agreed in advance and properly documented.

Sweat Equity in the form of options

If you do not want the recipient to become a shareholder immediately, or want to defer dilution until shares are acquired, options may be appropriate.

A share option gives the recipient the right to acquire shares in the future at an agreed exercise price. Options can be subject to vesting conditions based on time, performance or other agreed milestones.

The option holder does not become a shareholder merely by receiving the option. Exercise may take place on an exit or another permitted event, subject to the option terms. The timing of exercise and any resulting tax liability should be considered when designing the arrangement.

Advantages of options?

Options can provide a flexible way to incentivise employees without immediately transferring shares. Certain HMRC-approved schemes may also offer tax advantages to qualifying employees and employers.

One commonly used scheme is the Enterprise Management Incentive (EMI) scheme. EMI options can be granted to qualifying employees, subject to statutory eligibility requirements and limits. Consultants are not eligible for EMI options merely because they provide services to the company, although other incentive arrangements may be available.

Sweat Equity Agreement

Whatever structure is chosen, the arrangement should be clearly documented in the relevant option agreement, share subscription or transfer documents, shareholders’ agreement and, where appropriate, a separate sweat equity agreement.

We advise business owners, employees and service providers on structuring sweat equity arrangements, reviewing and drafting the necessary documents, and considering the associated tax, ownership and leaver issues.

Legal advice on start-up sweat equity

Sweat equity can help start-ups attract key people while managing cash expenditure. However, the structure should be designed with care, particularly where the business needs to retain control of its shares, manage future dilution or address what happens when a recipient leaves.

Please get in touch to discuss your proposed arrangement, the options available and an indication of the likely costs.