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.

Key Takeaway

Sweat equity can help startups and other businesses attract employees and other talent without expending precious funds. However, 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.