Sweat equity: how it works and why it matters to startups

Startup founders have given blood, sweat, and tears to get our startup off the ground. While the blood and tears were purely metaphorical, the sweat was all too real—those late nights coding, the weekends spent networking, the hours perfecting our pitch deck.

Sweat equity is the elbow grease startup teams put into their startup project. No, scratch that—it’s the back-breaking labor, the grind, the hustle. And what do you give startup advisors, early employees, and co-founders in exchange for their, get it, sweat?

In this article we talk about

Leah Brownlee, President and Legal Counsel of Lazurite, talks about how sweat equity is key to getting those first employees to align on the company's vision.

Now, this isn’t a get-rich-quick scheme or a magical solution to all your financial woes–but it can be a great way for startup founders to ensure that everyone involved in building the company can share in its success over time.

In this post, we’ll discuss everything you need to know about sweat equity and how startup founders can use it to build a successful team, even with limited resources. Let’s get started!

What is sweat equity

Ah, sweat equity. The fuel that drives startups forward. Sweet equity can work too—sweet like Cake, which, as you can see by now is very on-brand! But we digress.

Sweat equity is the concept of compensation without cash – employees and advisors are rewarded with a percentage of the company instead of a salary. It's what allows you to keep forging ahead on your mission, even when you don't have enough money to pay everyone on payroll (yet).

As a founder, you're offering something that no dollar amount can match: the chance to be part of an up and coming venture with huge potential in disrupting an industry. It's an opportunity for people to truly make their mark by investing their skills, knowledge, and time into your company – and ultimately, into themselves.

Why "sweat equity"

If there's one thing we know, it's that starting a business is hard work. It takes long hours, dedication to the cause and you guessed it – sweat – to bring a budding business idea to life. That's why we like to refer to it as 'sweat equity', and it's an essential tool for startup teams that are low on cash, but high on potential.

Sweat equity is the positive value of a company that results from the voluntary or involuntary investment of personal energy as opposed to financial capital. It can take many forms, such as sweat from working extra hours or sweat from negotiating beneficial deals for the business.

No matter how tight your budget is, you can find creative ways to compensate your team if you put some sweat into it – literally!

At Cake Equity, we think that sweat equity is an invaluable resource for building successful teams and finding long-term success for startups. And this is the motivation behind the Cake platform—we want to help startup founders offer equity, at every stage of growth, and from anywhere in the world.

Benefits of offering sweat equity to early team members and advisors

If you're a startup founder looking to offer early team members and advisors meaningful equity compensation, sweat equity has a lot to offer. It's an incredibly flexible and cost-effective way to reward those who have chosen to pull up their boot straps and help you build out your dream.

Michael Houck, ex-Airbnb and ex-Ubereats, now co-Founder of House Capital, believes in the importance of offering equity to early employees:

"Employee equity is super important. You want to make sure that employees, especially early employees who are making a huge commitment and taking a huge risk to bet on your startup versus one of the many of the other things they could do with their skills, are compensated for that and have the upside for that in the long run."

When offering sweat equity, there are three main benefits:

• Control. Sweat equity gives startup founders the flexibility to determine which individuals should be involved in the company before they raise their first round of funding. This allows them to create the right team dynamic from the start.
• Cost savings. When offering sweat equity, startup founders save on upfront costs as there is no need for salaries or paying advisors upon joining. It also avoids the potential issue of overvaluing the company too early resulting in dilution of ownership when raising funds from investors.
• Alignment. Sweat equity aligns interests between everyone involved in the project—it creates a "win-win" situation where everyone has an interest in seeing the success of the business and works together towards that goal.

When to use equity as an incentive and with whom

For starters, you should consider offering equity to the people who are most committed to seeing your venture succeed: your core team and advisors. They don’t come cheap, but they often represent the best return on investment in terms of expertise. And because they’re usually early adopters, offering them equity incentives can be mutually beneficial.

And if you’re looking to attract highly skilled talent for key roles but can’t afford hefty salaries yet, you can mix both cash and equity rewards to sweeten the deal.

Long-term incentives result in higher motivation, greater job satisfaction within the team and larger rewards for everyone at the end of the road. That means if you decide to go with sweat equity, make sure those who receive it understand the risks associated with this type of compensation—and that they’re fully onboard with your long term vision before signing anything.

How sweat equity works: vesting schedules and equity pools

We mean it when we say that sweat equity is an amazing tool for startup founders. But before you get all up in arms about leveraging it, let's take a look at exactly how it works.

At its core, sweat equity is about making sure that everyone involved in a startup project is compensated fairly and has a vested interest in seeing that project succeed. When startup founders offer sweat equity, they're typically doing so through vesting schedules and equity pools—and both are integral to the process.

Vesting schedules

With vesting schedules, employees are given stock options upfront but the shares vest over a period of time, usually four years. This way, employees remain loyal and show commitment to the company by steadily earning their shares of stock-based compensation.

Equity pools

Equity pools work much like vesting schedules—except instead of being allocated to individual employees, they’re placed into an equity pool where they accumulate until certain conditions (like milestones and revenue goals) are met. This way the whole team can benefit from their hard work in the long run.

With a proper understanding of vesting schedules and equity pools under your belt, you can leverage sweat equity (and Cake!) to successfully launch your own business with confidence!

Key considerations when structuring a sweat equity agreement

Sweat equity, when used correctly, can be a powerful tool in getting your startup off the ground. But as with any kind of contract, there's a right way and a wrong way to approach it.

Here are the key considerations you'll need to make when drafting a sweat equity agreement that works for everyone involved:

1. Role and equity: Ensure that equity is offered in exchange for work performed rather than just as an incentive. Also make sure the role of the employee or advisor is clearly defined so everyone understands what is expected from them.
2. Vesting: Set up vesting periods to protect against dilution and decide how much upfront equity will be granted versus in regular installments or milestones reached throughout the course of their employment.
3. Tax implications: Make sure you understand all applicable tax implications for both employer and employee/advisor—especially since regulations differ depending on the country where your company operates or where your team members live and work.
4. Timelines: Have an expected timeline for achieving certain objectives set out in each agreement including tax filing dates if necessary to make sure everything is taken care of on time without any surprises or last minute rushes.
5. Professional advice: Have a lawyer or professional review each agreement so as to avoid any loopholes or oversights in the future—it'll take some time up front but it'll more than pay off down the line!

How to have the sweat equity conversation with prospective team members

Okay, so you have an idea of what sweat equity is and why it's beneficial. Now, how do you actually start the process of offering sweat equity to employees, board members, or advisors?

For starters, it's important to remember that sweat equity isn't a one-size-fits-all solution. As each startup is unique, so too are the conversations surrounding sweat equity. However, there are some general rules that apply when approaching the topic.

These include:

1. Understand what you can offer: Before having the conversation, make sure that you understand all of the implications of your plan and what value you can provide to those involved.
2. Be transparent: Be clear and open about the terms of your offer to ensure that everyone is on the same page from day one.
3. Get agreement in writing: It's important to have a paper trail in order to ensure that everyone is comfortable with their arrangement.
4. Talk about timing: Make sure that it's clear when the appreciation will occur so that everyone knows what to expect.
5. Leverage technology: To streamline and simplify processes surrounding sweat equity, consider using an equity management software like Cake Equity.

By following these steps and having an honest conversation with prospective team members about how they will be compensated in sweat equity, you can ensure a fair outcome for all parties involved.

When it comes to bringing together a startup team with a real impact that can weather the initial turbulence that all startups experience, know that sweat equity is your secret weapon. By structuring your sweat equity agreement thoughtfully and transparently, you’ll not only be able to save your initial bootstrapping budget, but also ensure that everyone is aligned in building a successful venture.

In other words, if done correctly, you’re able to get the best of both worlds: getting the work done while giving everyone a sense of ownership. Sweat equity is the ultimate return on investment—not to mention the perfect motivation to jump into the exciting world of startups and entrepreneurship!