Sweat equity has been around since the dawn of entrepreneurship. Resource constrained founders ask friends and family for help starting a business. In return for their time, founders promise to reward them if the company is a success. When founders ask for money, they are typically required to provide a written agreement including repayment terms and some form of upside to compensate for risk. In recent years, convertible debt has become a preferred model for lending money to startups.
In a previous article, I advocated for combining these methods to create better incentives for startup advisors. I called it "Convertible Sweat". The objective is to encourage advisors to roll-up their sleeves and implement projects, not just give advice.
Convertible Sweat is extendible to all roles in a startup, not just advisors. A founder can implement the Convertible Sweat model using simple methods to track contributions and create opportunities to convert them to cash or equity.
Convertible Sweat enables entrepreneurs to build successful startups based on the strength of an idea and trust in fair compensation.
The first step in implementing Convertible Sweat is finding suitable partners. Founders should avoid pitching terms beyond the acceptable risk level of a partner, in the same way they might only pitch business angels that are accredited investors. If a potential partner is the bread-winner of a family with little savings, it's better to propose moonlighting than for them to quit their day job.
High profile developers, designers and growth-hackers are contacted regularly to work for startups. Convincing them to join will take more than a slick slide deck and a firm handshake. Before approaching them, you should develop a compelling mission statement and monetization strategy, then design a prototype and survey potential customers to prove the concept.
If you can't find suitable partners through your network, a growing number of sites such as Extra Founder can help you connect to people with complimentary skills and a passion for entrepreneurship.
If a founder inspires a contributor to work for deferred compensation, it is important to value their contribution fairly and associate a risk premium.
There are two main ways to value contribution. The first is to assign a market rate by looking at industry averages. The second is to consider the opportunity cost of the contributor. Regardless of the method used, a founder should consider several candidates and negotiate with the same zeal as if they were managing a burn rate.
Considering the time value of money, the most rigorous approach would be to agree on an interest rate to apply to the contribution. This would motivate the founder to convert the contribution as soon as possible. However, negotiating and calculating interest rates is time consuming. A better practice may be to assign a risk premium of between 2 and 3, regardless of time horizon.
Let's look at an example. Imagine a ride sharing startup called HitchLizard needs a web site developer. They might estimate the going rate to be $50/hour and apply a risk premium of 2. If the developer works on the project for 20 hours, the value of their contribution would be $50/hr * 20hrs * 2 = $2,000.
If HitchLizard is run like a bootstrapped startup, it may generate revenue early in its development. Depending on circumstances, the founder might distribute a portion to contributors. The money could be distributed pro rata or FIFO (first in first out).
Contributors should be given the option to forego payment and wait for an opportunity to convert to equity. This can be useful for discerning partners with a long term commitment.
Converting contribution to equity requires calculating the valuation of a company. Valuing startups is part science, part art, but mostly religion as it requires a leap of faith. It's a challenging exercise that often leads to disagreement. An elegant solution is to defer valuation to a yet unknown professional at a future date. In our example, HitchLizard could wait for a Venture Capital firm or syndicate of angel investors to make an acceptable offer. At that point, contributors would have the opportunity to convert their contributions to equity at similar terms to the new equity partners.
Let's look at an example and do the math. Imagine that Crabgrass Capital buys 20% of HitchLizard for $1 million, valuing the company at $5 million. The web developer could convert $2,000 of contribution into 0.04% of the equity ($2k / $5m * 100).
To compensate contributors for having accepted risk before the new equity partners, HitchLizard could sweeten the deal by offering a 10% discount on the valuation, so the web developer would get a 0.044% stake ($2k / ($5m * 0.9) * 100).
A valid concern of any risk sharing partner is the time horizon. When will I be able to cash out? VCs refer to this as an exit strategy. To improve liquidity for contributors, a startup can create an internal market to convert contributions. Opening this up to 3rd parties may introduce legal disputes so it should be discouraged or subject to the founder's approval.
Let say our web developer has a baby boy on the way and wants the circumcision done by the best plastic surgeon in Los Angeles. Ain't no place like Silicon Valley, right? They could offer to sell their contribution to another partner at face value $2,000. A more flexible approach would allow partners to place buy or sell orders which would be filled based on price, like financial markets.*
If the startup has sold equity but has not gone public, the internal market could easily be extended to trade equity in addition to contribution.
Why not just distribute equity instead?
There are a few problems inherent with "sweat equity" model practiced by many startups. One problem is that founders generally allocate equity based on the potential of an employee, not on the actual contribution. For example, a startup may give a considerable chuck of equity to a well-known individual. But what if that "guru" doesn't deliver and a lesser known partner works their tail off?
Adjusting equity fairly would require valuing the company on a regular basis and issuing new shares based on contribution. That's challenging to say the least. If a founder gets it wrong, moral will suffer and partners may become litigious.
Implementing a Convertible Sweat model is not trivial but is has advantages over other forms of financing. It is more robust than most sweat equity agreements. It conserves more equity for operational partners. If properly implemented, it provides liquidity earlier than alternatives. In a nutshell, Convertible Sweat brings the benefit of convertible debt to early contributors while bringing additional benefits startups.
July 26, 2015 Version 1.0