Six Key Mistakes to Avoid When Drafting a Sweat Equity Agreement

Startups are usually founded by two or more founders working together to pursue an ingenious idea. The team also consists of dynamic individuals who specialize in different fields and share a common dream.

Financial contributions are made by some Founders, while others provide intellectual property. Without the initial fundraise , how can each of them be compensated  for their hard work?

Understanding sweat equity is the key to solving the problem. Providing individuals with shares in a company is a way to value and reward their work. An agreement documenting this exchange is called a sweat equity agreement.

It is vital to understand the value of your startup before you hire new employees and attract investors. That strengthens your startup’s negotiating position when seeking funding.

Such an invaluable agreement needs to be crafted with care and precision. Worry not; we have brought you six critical mistakes to avoid when drafting a sweat equity agreement.

Six Key Mistakes to Avoid When Drafting a Sweat Equity Agreement

It can be challenging to draft sweat equity agreements. It raises some critical long-term questions:

For instance, since the sweat equity recipient gets all their equity in a specific time frame, do they stay on longer? 

In the same way, if a person receives equity, is there a guarantee that they will live up to their expectations?

Early-stage startups who consider offering sweat equity shares often face these questions. Founders typically don’t include a vesting period or limits on the percentage or number of shares issued.

Despite their apparent triviality, these mistakes are costly for the startup. Let’s see what they are:

1. Not restricting equity amount

Irrespective of the expertise, an individual  simply can’t possess an unlimited amount of equity. Thus, a limit on the amount of sweat equity is essential.

For example, a limit of 10% is reasonable. Upon achieving certain milestones, the person may receive 10% of the equity, which may be given over some time.

2. Absence of vesting period clauses

Vesting is the period that a contributor must wait for before they start getting equity shares. In the absence of the same, there would be no incentive to stay. Therefore, equity allocation should be staggered over time. Vested period clauses are a vital part of sweat equity agreements.

As a general rule, if the  contributor  quits or is disengaged  before the vesting period, they forfeit any remaining benefits.

A startup’s vesting period is determined based on the expertise and commitment of partners and early-stage employees. There is no cliff for a founder to receive 25% equity as a sign-on bonus. In contrast, a 30% shareholder may have to wait two years to acquire full ownership.

3. Missing the type of equity clause

Vesting period decisions influence the allocation of types and quantities of shares. Sweat equity agreements will differ based on the partner’s expertise and value to the business. Hence clause stating the kind of equity the entitled contributor will get is crucial. 

4. No milestone clauses 

Establish milestones for the employee to ensure that they are performing well—link equity issues to these milestones. A milestone is a specific achievement needed to achieve equity.

Employees who are granted equity are given milestones to ensure that they perform at the level expected. Milestone clauses serve a similar function as vesting periods do. Hence, it helps determine who deserves to be part of the equity pool based on commitment and value contribution.

5. Unclear performance criteria clause

To ensure fair compensation for the intangible contributions made by individuals, sweat equity agreements must explicitly specify the scope of their contributions.

The performance criteria must be precisely outlined. If clarity cannot be established on the same, it could adversely affect either of the parties. Performance criteria clarify the contributors participation in the work for which they will not be compensated. 

They also clarify the founder’s flexibility in deeming specific tasks they have already agreed to be paid.

6. No exit or termination clause

Sweat equity agreements should include proper exit/termination clauses. Termination grounds should consist of failure to meet performance criteria or breaching company policies.

Make the exit process smooth for the employee who is also a shareholder in your company. Furthermore, it is anticipated that non-vested shares would lapse upon termination.

It is not easy to draft a sweat equity agreement due to the many factors to consider. The process is best handled by the experts. We have drafted sweat equity agreements for budding businesses to acquire the right talent at trica equity. Should you need assistance, our team is always ready to help.

Get started by scheduling a demo today!