Sweat equity – shares or options?

What is Sweat Equity?

Usually applying to start-ups, sweat equity simply means where an employee or consultant or service provider agree to accept payment in shares rather than cash.

The obvious advanatge for an early stage business is the payment via equity does not drain immediate cash in the way paying cash does.

Early stage businesses may be keen on  sweat equity because it  incentivises those working in the business and gets them invested (literally!) into the future of the company and the achievement of the management’s goals: usually an exit by way of a sale or listing when the holder of the shares will receive cash.

In the UK and elsewhere sweat equity is seen as a way of developing the business at a time when there is not the money around to pay wages.

Are there different types of sweat equity?

Yes and the approach depends on what you are trying to achieve and is likely to be influenced by the type of recipient. The main choice is between shares or options.

Equity shares

If you want the employee to be a new shareholder then an existing shareholder can transfer some of his or her shares or new shares could be allotted. New shares dilute the interests of all shareholders.

If the recipient is a director or employee, the  equity shares will be regarded as “employment related securities” and the recipient will pay income tax on the value of the shares as if they were receiving salary. In terms of tax, this may not be too much of a problem if the company is in the start-up phase and the shares have a low value. But the value of the equity shares will be an issue if the company has already built up value as the tax bill is greater.

Where this is the case, one possibility may be to give the recipient growth shares which have a low value on a grant, because they only see benefit where there is an exit at a value over a specified

Key considerations where Sweat Equity Shares

• Drawing up a share dilution table is a very good way to gain an oversight on who will benefit from the equity and by how much. It focuses the mind on planned future events and helps to stop eager founders giving too much away.
•  The recipient will have rights as a shareholder so, depending on the rights attaching to the shares, they may have rights to attend meetings, vote and shall in dividends etc. You can create different rights for different people.
•  Usually you need a shareholders agreement. You need to think about what will happen when a shareholder leaves – will he or she be forced to transfer their shares? The shareholders’ agreement is an area where the most thought is required.
•  There is tax reporting required to HMRC and elections needed to preserve the tax liability for the recipient.
• Depending on the role of the recipient within the organisation, you may want to ensure the recipient has some “skin in the game now”, in which case you would not give the equity away for free. The directors can set any purchase price they see fit and it can be higher or lower than market value.
• With shares once given away there is no giving them back unless agreed. If the company is doing well it is unlikely anyone would agree to give back shares. Why would they?

Sweat Equity in the form of options

If you don’t necessary want the desired recipient to be involved as a shareholder or dilute other shareholdings now, options may be the answer.

A share option gives the recipient the right to acquire shares at an agreed price in future and may be subject to vesting conditions (in terms of time after the option was granted or performance criteria).

The option holder does not actually become a shareholder now and often will not exercise until exit (so they will have cash to pay any tax arising on exercise) or until the end of the option period – often 10 years from grant.

Advantages of options?

An advantage of granting options is that there are various tax efficient share option schemes for employees (but not for consultants) and for the employer company. The one that we see used most frequently is the Enterprise Management Incentive (EMI) Scheme:

The benefit of EMI Options is that EMI options can be offered to selected employees and they are flexible but you do have to stay within the limits of the legislation.

Sweat Equity Agreement

For any arrangement reached, it’s essential this is clearly documented, either by shareholder agreement or separate sweat equity agreement. If you need advice, either as business owner or employee, on the terms of an agreement or want an agreement dratted, we are a highly competent, practical and cost efficient choice.

Solicitors for advice on start up sweat equity

There are a number of alternatives available to incentivise the key players in a team whilst keeping control of wages via the use of sweat equity. Many starts up were established and now thrive on sweat equity. Key considerations are ways to reclaim the equity if the recipient leaves and the tax aspects.

Please do get in touch for a discussion and information on what we can help with and what it would cost.