Failure to Document “Sweat Equity” Agreements Can Lead to Costly Suits

Failure to Document “Sweat Equity” Agreements Can Lead to Costly Suits

For startup companies and other cash-strapped businesses, so-called “sweat equity” can be extremely beneficial...

For startup companies and other cash-strapped businesses, so-called “sweat equity” can be extremely beneficial. While many startups are unable to reward founders and employees for their hard work with monetary compensation, they can award an equity interest in the company.

What Is Sweat Equity?

The term “sweat equity” broadly refers to the value-enhancing improvements generated from the sweat of your brow. Sweat equity can take a variety of forms. In real estate, investors may perform some of the work themselves to lower the costs of the project and increase the return when the property is sold. In the corporate context, sweat equity is the contribution that a company's stakeholders make in the form of labor and time rather than money. In exchange for the benefits the company receives, stakeholders are generally awarded shares in the company, which are referred to as “sweat equity shares.”

The value of sweat equity can also be calculated in a variety of ways. In a partnership, sweat equity is generally calculated based on each partner’s time and effort in building the business. Other examples include the compensation that an employee would make performing the same task somewhere else, the amount the company would have to pay to someone else to perform the same tasks, and the estimated increase in value that the individual’s work has generated. In many cases, businesses will rely on more than one factor.

Importance of Sweat Equity Agreements

Whatever the form sweat equity takes, it is important to memorialize it in a legally binding agreement. Often referred to as a “sweat equity agreement,” these contracts should expressly state what is expected of a recipient (partner, employee, consultation, etc.) and how the work will be compensated.

A recent New York lawsuit highlights that relying on a handshake agreement or a poorly-drafted agreement can often lead to disputes. In Kakarla v. Penakalapati, Plaintiff Swamijee Kakarla (Plaintiff) asserts numerous claims against defendants Sameer Penakalapati (Penakalapati), Avani Technology Solutions, Inc. (Avani), Ceipal Corp. (Ceipal), Avani Business Park, LLC (ABP), and Indotronix International Corp. (Indotronix) (collectively “Defendants”) related to his claimed ownership interest in the corporate defendants. 

According to court documents, the Plaintiff claims that he and Penakalapati jointly agreed to develop Avani as an information technology business and that because “Penakalapati could not afford to pay a salary to [Plaintiff] and officially bring him to Avani as an employee, . . . Penakalapati promised [Plaintiff] 20% interest in Avani if [Plaintiff] agreed to work to build the new company in his free time.” Plaintiff further claims to have been promised that he would “receive 20% ‘sweat equity' in any future ventures related to or stemming from Avani.” While the Defendants acknowledge that Penakalapati and Plaintiff “had discussed Plaintiff working for sweat equity in lieu of salary, ” they maintain that “before Plaintiff left MGL to join Avani, [Penakalapati] determined that Plaintiff had to be paid the prevailing wage and could not work for sweat equity or be an owner of the company.”

In January 2010, Penakalapati gave Plaintiff a stock certificate (Stock Certificate) for 20 shares in Avani. The Stock Certificate was dated January 16, 2010, and indicated that Avani was authorized to issue 200 common shares. The Defendants maintain that Penakalapati gave the Stock Certificate to Plaintiff before he learned that, consistent with the terms of his H1-B visa, “Plaintiff had to be paid the prevailing wage and could not work for sweat equity.”

In 2010 and 2011, Penakalapati provided Plaintiff with employment agreements providing for an annual salary as compensation for working for Avanti. However, Plaintiff maintains that Penakalapati repeatedly restated his promise to [Plaintiff] that he was entitled to a 20% interest” in businesses acquired by Penakalapati. Defendants assert that on November 21, 2016, Penakalapati “informed Plaintiff that Avani would not provide him with equity but Avani would increase his annual salary to $135,000 and provide a $7,500 bonus for every 10 million dollars of revenue.” A subsequent December 2, 2016 letter thanked Plaintiff for his contributions to Avani, stated that Penakalapati was “hopeful that [Plaintiff] would continue to be one of the key people for Avani, ” and stated a desire to pay Plaintiff “a bonus of cash and/or stock” when Avani reached revenue of $100 million per year. Plaintiff acknowledges having received and signed the December 2016 Letter.

Plaintiff maintains that later in the day on December 2, 2016, Penakalapati approached him and demanded that he return the Stock Certificate, asserting that Plaintiff must do so because he had signed the December 2016 Letter. Plaintiff further claims that he initially refused to return the Stock Certificate, but that Penakalapati told him that if he did not comply, Penakalapati would revoke Plaintiff's H1-B visa. Plaintiff eventually found another position and resigned from Avani effective April 14, 2017. Later that year, he filed suit in the U.S. District Court for the Western District of New York.

In ruling on the Defendants' motion for summary judgment, the court rejected the Plaintiff’s declaratory judgement claim to the extent that he asked the court to declare that he owns 20 shares in the company. As the court explained:

To the extent that Plaintiff seeks a declaratory judgment that he is the owner of 20% of Avani and the other corporate defendants, the Court agrees with Defendants that summary judgment is appropriate. While there is a genuine dispute between the parties as to whether Penakalapati agreed to give Plaintiff a 20% ownership interest in return for Plaintiff working for Avani without pay, the record is clear that the only step taken to actually consummate any such agreement was the delivery of the Stock Certificate. Indeed, Plaintiff's own Counterstatement of Uncontested Facts acknowledges that his purported “20% sweat equity interest” was never formalized and that while at one point he “believed . . . that he would soon receive a 20% interest in all of the defendant companies as a reward for [his] sacrifice, ” he eventually realized that “Penakalapati's promise to award 20% sweat equity would never come to fruition[.]” In other words, even accepting as true Plaintiff's version of events, Penakalapati promised 20% ownership of Avani and the other corporate defendants, but never took the steps necessary to fulfill that promise.

The court further explained that a request for a declaratory judgment “is not a vehicle to force compliance with contractual obligations, and cannot be used to alter the legal relationship between two parties, rather than to state the details of the legal relationship.” Accordingly, it found that the Plaintiff couldn’t obtain a declaration that he is the owner of 20% of Avani or any of the other corporate defendants “because he indisputably is not, regardless of whether, as he claims, he should have been made such.”

Nonetheless, the court found that genuine issues of material fact existed as to Plaintiff's claim that he is an owner of 20 shares of Avani. “It is undisputed that Penakalapati delivered the Stock Certificate to Plaintiff in January of 2010 and that the Stock Certificate on its face indicates that Plaintiff owns 20 shares of Avani,” the court wrote. “On the record before the Court, a rational jury could conclude that Plaintiff obtained 20 shares of Avani in January 2010 in exchange for his agreement to work with pay to get the new business venture up and running.”

In addition, the court found there were further genuine issues of material fact surrounding the circumstances under which the Stock Certificate was returned to Penakalapati. “Defendants contend that Plaintiff ‘voluntarily relinquished the [Stock] Certificate for [c]onsideration’ —specifically, the increased salary and bonuses he was awarded in late November 2016,” the court wrote. “However, acceptance of this argument would require the Court to discount Plaintiff's testimony that Penakalapati did not ask him to return the Stock Certificate until December 2, 2016, and that Penakalapati claimed Plaintiff was obligated to do so because he had signed the December 2016 Letter (and not because he had accepted a salary increase in late November 2016). This is precisely the sort of factfinding that the Court cannot engage in when deciding a motion for summary judgment.”

Key Takeaway

Sweat equity can help startups and other businesses attract employees and other talent without expending precious funds. However, as the court’s decision in Kakarla v. Penakalapati highlights, claims of sweat equity can lead to long, and often expensive, lawsuits. To avoid a similar fate, startups and other businesses should take care to document the expectations of all parties in a written agreement. It is also important to memorialize any changes to the sweat equity arrangement as the business evolves.

If you have questions, please contact us

If you have questions or if you would like to discuss the matter further, please contact me, Dan Brecher, or the Scarinci Hollenbeck attorney with whom you work, at 201-896-4100.


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Failure to Document “Sweat Equity” Agreements Can Lead to Costly Suits

Failure to Document “Sweat Equity” Agreements Can Lead to Costly Suits
Author: Dan Brecher

For startup companies and other cash-strapped businesses, so-called “sweat equity” can be extremely beneficial. While many startups are unable to reward founders and employees for their hard work with monetary compensation, they can award an equity interest in the company.

What Is Sweat Equity?

The term “sweat equity” broadly refers to the value-enhancing improvements generated from the sweat of your brow. Sweat equity can take a variety of forms. In real estate, investors may perform some of the work themselves to lower the costs of the project and increase the return when the property is sold. In the corporate context, sweat equity is the contribution that a company's stakeholders make in the form of labor and time rather than money. In exchange for the benefits the company receives, stakeholders are generally awarded shares in the company, which are referred to as “sweat equity shares.”

The value of sweat equity can also be calculated in a variety of ways. In a partnership, sweat equity is generally calculated based on each partner’s time and effort in building the business. Other examples include the compensation that an employee would make performing the same task somewhere else, the amount the company would have to pay to someone else to perform the same tasks, and the estimated increase in value that the individual’s work has generated. In many cases, businesses will rely on more than one factor.

Importance of Sweat Equity Agreements

Whatever the form sweat equity takes, it is important to memorialize it in a legally binding agreement. Often referred to as a “sweat equity agreement,” these contracts should expressly state what is expected of a recipient (partner, employee, consultation, etc.) and how the work will be compensated.

A recent New York lawsuit highlights that relying on a handshake agreement or a poorly-drafted agreement can often lead to disputes. In Kakarla v. Penakalapati, Plaintiff Swamijee Kakarla (Plaintiff) asserts numerous claims against defendants Sameer Penakalapati (Penakalapati), Avani Technology Solutions, Inc. (Avani), Ceipal Corp. (Ceipal), Avani Business Park, LLC (ABP), and Indotronix International Corp. (Indotronix) (collectively “Defendants”) related to his claimed ownership interest in the corporate defendants. 

According to court documents, the Plaintiff claims that he and Penakalapati jointly agreed to develop Avani as an information technology business and that because “Penakalapati could not afford to pay a salary to [Plaintiff] and officially bring him to Avani as an employee, . . . Penakalapati promised [Plaintiff] 20% interest in Avani if [Plaintiff] agreed to work to build the new company in his free time.” Plaintiff further claims to have been promised that he would “receive 20% ‘sweat equity' in any future ventures related to or stemming from Avani.” While the Defendants acknowledge that Penakalapati and Plaintiff “had discussed Plaintiff working for sweat equity in lieu of salary, ” they maintain that “before Plaintiff left MGL to join Avani, [Penakalapati] determined that Plaintiff had to be paid the prevailing wage and could not work for sweat equity or be an owner of the company.”

In January 2010, Penakalapati gave Plaintiff a stock certificate (Stock Certificate) for 20 shares in Avani. The Stock Certificate was dated January 16, 2010, and indicated that Avani was authorized to issue 200 common shares. The Defendants maintain that Penakalapati gave the Stock Certificate to Plaintiff before he learned that, consistent with the terms of his H1-B visa, “Plaintiff had to be paid the prevailing wage and could not work for sweat equity.”

In 2010 and 2011, Penakalapati provided Plaintiff with employment agreements providing for an annual salary as compensation for working for Avanti. However, Plaintiff maintains that Penakalapati repeatedly restated his promise to [Plaintiff] that he was entitled to a 20% interest” in businesses acquired by Penakalapati. Defendants assert that on November 21, 2016, Penakalapati “informed Plaintiff that Avani would not provide him with equity but Avani would increase his annual salary to $135,000 and provide a $7,500 bonus for every 10 million dollars of revenue.” A subsequent December 2, 2016 letter thanked Plaintiff for his contributions to Avani, stated that Penakalapati was “hopeful that [Plaintiff] would continue to be one of the key people for Avani, ” and stated a desire to pay Plaintiff “a bonus of cash and/or stock” when Avani reached revenue of $100 million per year. Plaintiff acknowledges having received and signed the December 2016 Letter.

Plaintiff maintains that later in the day on December 2, 2016, Penakalapati approached him and demanded that he return the Stock Certificate, asserting that Plaintiff must do so because he had signed the December 2016 Letter. Plaintiff further claims that he initially refused to return the Stock Certificate, but that Penakalapati told him that if he did not comply, Penakalapati would revoke Plaintiff's H1-B visa. Plaintiff eventually found another position and resigned from Avani effective April 14, 2017. Later that year, he filed suit in the U.S. District Court for the Western District of New York.

In ruling on the Defendants' motion for summary judgment, the court rejected the Plaintiff’s declaratory judgement claim to the extent that he asked the court to declare that he owns 20 shares in the company. As the court explained:

To the extent that Plaintiff seeks a declaratory judgment that he is the owner of 20% of Avani and the other corporate defendants, the Court agrees with Defendants that summary judgment is appropriate. While there is a genuine dispute between the parties as to whether Penakalapati agreed to give Plaintiff a 20% ownership interest in return for Plaintiff working for Avani without pay, the record is clear that the only step taken to actually consummate any such agreement was the delivery of the Stock Certificate. Indeed, Plaintiff's own Counterstatement of Uncontested Facts acknowledges that his purported “20% sweat equity interest” was never formalized and that while at one point he “believed . . . that he would soon receive a 20% interest in all of the defendant companies as a reward for [his] sacrifice, ” he eventually realized that “Penakalapati's promise to award 20% sweat equity would never come to fruition[.]” In other words, even accepting as true Plaintiff's version of events, Penakalapati promised 20% ownership of Avani and the other corporate defendants, but never took the steps necessary to fulfill that promise.

The court further explained that a request for a declaratory judgment “is not a vehicle to force compliance with contractual obligations, and cannot be used to alter the legal relationship between two parties, rather than to state the details of the legal relationship.” Accordingly, it found that the Plaintiff couldn’t obtain a declaration that he is the owner of 20% of Avani or any of the other corporate defendants “because he indisputably is not, regardless of whether, as he claims, he should have been made such.”

Nonetheless, the court found that genuine issues of material fact existed as to Plaintiff's claim that he is an owner of 20 shares of Avani. “It is undisputed that Penakalapati delivered the Stock Certificate to Plaintiff in January of 2010 and that the Stock Certificate on its face indicates that Plaintiff owns 20 shares of Avani,” the court wrote. “On the record before the Court, a rational jury could conclude that Plaintiff obtained 20 shares of Avani in January 2010 in exchange for his agreement to work with pay to get the new business venture up and running.”

In addition, the court found there were further genuine issues of material fact surrounding the circumstances under which the Stock Certificate was returned to Penakalapati. “Defendants contend that Plaintiff ‘voluntarily relinquished the [Stock] Certificate for [c]onsideration’ —specifically, the increased salary and bonuses he was awarded in late November 2016,” the court wrote. “However, acceptance of this argument would require the Court to discount Plaintiff's testimony that Penakalapati did not ask him to return the Stock Certificate until December 2, 2016, and that Penakalapati claimed Plaintiff was obligated to do so because he had signed the December 2016 Letter (and not because he had accepted a salary increase in late November 2016). This is precisely the sort of factfinding that the Court cannot engage in when deciding a motion for summary judgment.”

Key Takeaway

Sweat equity can help startups and other businesses attract employees and other talent without expending precious funds. However, as the court’s decision in Kakarla v. Penakalapati highlights, claims of sweat equity can lead to long, and often expensive, lawsuits. To avoid a similar fate, startups and other businesses should take care to document the expectations of all parties in a written agreement. It is also important to memorialize any changes to the sweat equity arrangement as the business evolves.

If you have questions, please contact us

If you have questions or if you would like to discuss the matter further, please contact me, Dan Brecher, or the Scarinci Hollenbeck attorney with whom you work, at 201-896-4100.