Sweat Equity is a creative and effective way for a startup to get early traction prior to raising capital, but it is fraught with potential legal and tax pitfalls for both the Company issuing the Sweat Equity and the Consultant contributing effort to the Company in exchange for Sweat Equity.

Because the process is not well-understood, Sweat Equity is rarely done right. The following infographic delves deeper into this issue:

What is sweat equity?

In the startup realm, Sweat Equity is the exchange of one’s time and talent for compensation other than cash from a startup. We call the contributor a “Consultant” and the payor a “Company.”

Sweat Equity Scenario

A typical tech startup goes something like this: a founder has a brilliant idea, but he or she is not quite sure how to build out their vision, so they attempt to raise seed capital or venture capital, but they are usually sent packing because they don’t have a product. No one wants to invest in a vision. The Company needs a minimum viable product with real customers and market traction in order to attract investment. The entrepreneur then tries to figure out how to get the product built without funding.

Enter Sweat Equity, the popular – but often poorly-executed – notion of hiring a Consultant to work in exchange for equity in the Company. The danger is that Sweat Equity arrangements often don’t go well because the work is typically not well defined, often not well delivered, and promises of equity are often not kept, resulting in unmet expectations and a bad business divorce.

3 Key Concepts of Sweat Equity

1. Forms of Sweat Equity The type of Sweat Equity can take on many different forms, from founder’s stock to a stock warrant to a revenue royalty, or even a SAFE (Simple Agreement for Future Equity) or a Convertible Note, both of which convert into Series A preferred shares in a qualifying venture capital round.
2. Risk Premium Sweat Equity compensation needs to involve sufficient upside value to offset the risk of trading time for an uncertain future outcome, known as the “risk premium”.
3. Mix of Compensation In many cases, when a Consultant is contributing effort to a Company, they will need some amount of cash in order to sustain their living expenses. Therefore, it’s often important to keep Sweat Equity arrangements flexible with a mix of some cash and some risk premium in the form of non-cash Sweat Equity compensation.

3 Key Considerations of Sweat Equity

The tax consequences of the different forms vary widely in terms of the type of tax and the timing of the tax liability as well as potential legal ramifications.

1. Tax Considerations One way to think about Sweat Equity is that while a typical two-step process may be shortened to only one step, the Sweat Equity compensation can still potentially be viewed and taxed by taxing authorities such as the IRS as if the Consultant was 1) paid in Cash (which is generally taxable at personal income tax rates, but varies based upon the Consultant’s entity type and tax situation), and then, 2) turns around and invests the Cash in the Company in exchange for some form of variable upside.We’ve summarized the potential tax consequences in our complete Sweat Equity eBook in our comparisons of the various forms of Sweat Equity, but we strongly recommend that you get both legal and tax advice on each of your Sweat Equity agreements since individual situations vary and we are only selling templates, not giving tax, legal, or investment advice.
2. Legal ConsiderationsOther considerations are the legal impacts of a Consultant taking ownership in a Company by, in essence, investing in securities and the potential legal risks of such equity ownership.
3. Investment ConsiderationsFinally, when Sweat Equity contributors are being compensated in equity in the form of equity or stock warrants, or compensated with debt-like instruments such as a SAFE or a Convertible Note that convert into equity, the Consultant is making an equity investment decision and should do plenty of due diligence given the risky nature of a startup investment. A Consultant working for Sweat Equity is potentially required to be an accredited investor to make such an investment.

5 Aspects of Managing Sweat Equity

Sweat Equity is a complex process that must be properly managed. When structuring a deal, entrepreneurs should think through and define the following five aspects of managing Sweat Equity:

1. The Relationship

Many founders with a vision will look for a co-founder to help them build the vision (let’s assume for illustrative purposes that the founder needs someone to build them an app) and offer them founder’s equity amounting to a specific percentage of the Company.

However, granting the Consultant founder’s equity can be problematic.

It is akin to deciding to marry someone after a few dates: it doesn’t always work out as you had hoped. While giving a Consultant a “co-founder” title is fairly easy, committing to give them a significant ownership stake is far different.

It is very easy for relationships to sour, commitment levels and priorities to change, and significant gaps in skills and abilities to be discovered. Further, it is very difficult to get founder’s equity back. It is far better to manage any effort invested in your startup with shorter, smaller chunks of work that have clear deliverables and deadlines and a specified value.

Over time, with many successful deliverables, the amount of sweat equity can accumulate at the appropriate value and a co-founder title can always be offered once a significant contribution has been made.

Best Practice:

Do Not focus on finding a co-founder that will magically fill in all the gaps and deliver a killer app in exchange for Sweat Equity.

Do focus on managing the process of finding specific talent that can contribute a specific deliverable at a negotiated market value in exchange for a specific amount of Sweat Equity.

2. The Deliverables

Managing a project when compensating with Sweat Equity is no different than managing any other type of project. Good project management disciplines still apply: 1) clearly defining the deliverables, 2) managing the project communication, and 3) managing the execution of the deliverables (such as with daily sprint meetings) in order to have a successfully-completed, on-time project.

Rather than attempting to “boil the ocean”, it is far better to break up the work into small, manageable projects. Very few individual Consultants are even capable of delivering an entire app because of the various skills required to do so. A typical app development project requires expertise from UX/UI design to database architecture to app development to testing to documentation, etc.

App development is a complex project requiring many skills at both the individual contributor level and the management level in order to be successfully executed.

Best Practice:

Do Not hand off the buildout of your entire app to someone else in a Sweat Equity arrangement.

Do focus on managing the successful completion of one specific deliverable at a time with a high degree of control and accountability to keep everything on track.

3. The Compensation

It is a mistake to think of Sweat Equity as paying a Consultant to develop an entire app in exchange for founder’s equity. In reality, as mentioned above, very few Consultants can afford to be paid only in equity.

Paying in equity can also have adverse tax consequences for the Consultant. When following the best practice of breaking up the necessary work into smaller, more manageable deliverables, both sides have the opportunity to properly negotiate the market value of the particular deliverable and have the flexibility to change how the work is compensated with a different mix of cash vs. Sweat Equity from project to project to best meet the needs of both sides.

Best Practice:

Do Not attempt to pay for all work to be done in all equity.

Do negotiate each deliverable at the market rate for the Consultant’s work with an appropriate mix of compensation and risk premium that best suits the needs of the Company and the Consultant.

4. The Alignment of Risk and Reward

The definition of Sweat Equity should be broadened to include the various forms discussed above to create the best alignment between the Company and the Consultant.

For example, if a Company is rolling out multiple products, but the Consultant is only working on one of them, it would make sense to set up a Royalty arrangement tied to the sales of that one product. This would align the Consultant’s deliverable of that product to the Consultant’s upside, if the product is successful in the marketplace.

Additionally, the Consultant does not have to wait for an exit event but is paid along the way as the product’s sales generate revenue. Key considerations of Sweat Equity risk and reward include: the percentage of cash vs. Sweat Equity, the tax consequences, the type and amount of risk premium upside, the timing of the upside, and the basis for measuring the upside.

Best Practice:

Do Not limit your thinking on how Sweat Equity is typically paid.

Do be creative and flexible on how you develop Sweat Equity arrangements that are best suited for the given context and that create the best alignment between the Company and the Consultant.

5. The Expectations

Every entrepreneur and startup team is enthusiastic in the early phases. That enthusiasm is risky because it can result in emotional rather than rational decisions, like deciding to get married after a great first date. Startup outcomes fit into a typical bell curve of successes and failures.

Further, because the average age of startup founders and Consultants is often in the 20s and 30s, the life situation of those participating in Sweat Equity arrangements is often in flux (finishing a formal education, relationships, marriage, starting a family, etc.). Companies should build as much flexibility as possible into these arrangements to accommodate for a context that is likely to change.

Best Practice:

Do Not only assume the best possible outcome, nor assume that the context and commitment of all participants in their startup will remain unchanged.

Do manage for the downside as well and plan for such contingencies and build in as much flexibility into Sweat Equity arrangements as possible.

6 Forms of Sweat Equity

Sweat Equity can be issued in a variety of forms, including the following:

1. Founder’s Equity

Definition

A specific amount of equity issued only at the formation of the Company

Degree of Flexibility

Not very flexible – it is difficult to ever get Founder’s Equity back if things don’t work out with the Consultant unless the units are restricted or subject to a buy/sell agreement, which drives up legal cost and complexity

Potential Tax Consequences

Non-taxable at issuance unless Phantom Income was created if the Founder contributed capital, Capital Gains tax upon an exit

Type of Upside

The same common stock or units as the primary founder

Basis of Sweat Equity Value

Overall value of the company

Realizing the Value of Sweat Equity

Only

Only upon a successful exit

Current Valuation of the Company

Ideally the consultant is issued the amount of equity that equals the value of their contribution divided by the sum of the negotiated pre-money value of the Company, and the value of the contribution, e.g. if it is agreed that the Consultant’s contributed value is a total of $250k and the negotiated value of the Company prior to issuing the Sweat Equity is $1m, then the Consultant’s Founder’s Equity should be calculated as follows $250,000/($1,000,000 +$250,000) = 20%

Other Consequences

No downside protection for the Consultant if the Company fails, little downside protection for the Company if the Consultant fails to deliver

2. Company Equity Issued After Founding

Definition

A specific amount of equity issued only at the formation of the Company

Degree of Flexibility

Very flexible – can issue small amounts for specific deliverables at any point in the life of the Company

Potential Tax Consequences

Taxable at personal income tax rates at issuance (this Phantom Income can be a huge negative surprise to a Consultant that only received stock and no cash to pay the cost of the tax implications), plus Capital Gains tax upon an exit

Type of Upside

The same common stock or units as the primary founder

Basis of Sweat Equity Value

Overall value of the company

Realizing the Value of Sweat Equity

Only upon a successful exit

Current Valuation of the Company

Ideally the consultant is issued the amount of equity that equals the value of their contribution divided by the sum of the negotiated pre-money value of the Company, and the value of the contribution, e.g. if it is agreed that the Consultant’s contributed value is a total of $250k and the negotiated value of the Company prior to issuing the Sweat Equity is $1m, then the Consultant’s Founder’s Equity should be calculated as follows $250,000/($1,000,000 +$250,000) = 20%

Other Consequences

No downside protection for the Consultant if the Company fails, the downside protection for the Company if the Consultant fails to deliver is through the process of issuing only a small amount of equity for small projects

3. Stock Warrant

Definition

An option to purchase a specific amount of equity for a specific exercise price

Degree of Flexibility

Very flexible – can issue small amounts for specific deliverables at any point in the life of the Company

Potential Tax Consequences

Non-taxable at issuance as it does not create a Phantom Income (the fact that the Consultant is paying for the equity when exercising the Warrant gives them basis), Capital Gains tax upon an exit if the Warrant was exercised at least one year prior to exit

Type of Upside

The same common stock of units as the primary founder

Basis of Sweat Equity Value

Overall value of the company

Realizing the Value of Sweat Equity

Only upon a successful exit

Current Valuation of the Company

Ideally the consultant is issued the amount of equity that equals the value of their contribution divided by the sum of the negotiated pre-money value of the Company, and the value of the contribution, e.g. if it is agreed that the Consultant’s contributed value is a total of $250k and the negotiated value of the Company prior to issuing the Sweat Equity is $1m, then the Consultant’s Founder’s Equity should be calculated as follows $250,000/($1,000,000 +$250,000) = 20%

Other Consequences

The nominal cost of a low exercise price more than offsets the personal income tax rate that is avoided at issuance. No downside protection for the Consultant if the Company fails, and no downside protection for the Company if the Consultant fails to deliver. Note: we recommend issuing warrants instead of Common Equity after Founding because of the negative tax consequences of simply issuing Common Equity. Be sure to seek competent tax advice when deciding on how to issue or receive equity.

4. Royalty

Definition

A specific percent of a specific type of revenue that is paid out on a periodic basis within specific terms

Degree of Flexibility

Very flexible – can issue multiple royalty agreements or update a previous one to compensate for additional deliverables over the life of the Company

Potential Tax Consequences

Taxable at personal income tax rates whenever a royalty payment is made

Type of Upside

A percentage of revenue

Basis of Sweat Equity Value

The revenue of the Company or one or more of its offerings

Realizing the Value of Sweat Equity

Paid along the way, typically on a monthly or quarterly or annual basis

Current Valuation of the Company

No valuation is required

Other Consequences

The Consultant does not have to wait for an exit to realize the value of their contribution and the Company does not have to pay any royalty if the app doesn’t get completed or produce any revenue

5. SAFE (Standard Agreement for Future Equity)

Definition

An agreement for a specific dollar amount of contribution that converts into equity upon a venture capital investment

Degree of Flexibility

Very flexible – can issue multiple SAFE agreements over the life of the Company

Potential Tax Consequences

Taxable at personal income tax rates upon conversion (this can be a huge negative surprise to a Consultant that only received a SAFE and no cash to pay the cost of the tax implications), plus Capital Gains tax upon exit

Type of Upside

Convert to the same equity as venture capital investors, typically Series A Preferred equity, which has more preferences than the founder’s common equity

Basis of Sweat Equity Value

Overall value of the company

Realizing the Value of Sweat Equity

Only upon an exit

Current Valuation of the Company

No valuation is required

Other Consequences

No downside protection for the Consultant if the Company fails, the downside protection for the Company if the Consultants fails to deliver is through the process of issuing only a small amount of equity via the SAFE for small projects

6. Convertible Note

Definition

An agreement for a specific dollar amount of contribution that is either paid back in debt with interest by the Company to the Consultant, or that converts into equity upon a venture capital investment.

Degree of Flexibility

Very flexible – can issue multiple Convertible Notes over the life of the Company

Potential Tax Consequences

Taxable at personal income tax rates upon issuance (this can be a huge negative surprise to a Consultant that only received a Convertible Note and no cash to pay the cost of the tax implications), plus Capital Gains tax upon an exit

Type of Upside

Converts to the same equity as venture capital investors typically Series A Preferred equity, which has more preferences than the founder’s common equity

Basis of Sweat Equity Value

Overall value of the company

Realizing the Value of Sweat Equity

Only upon an exit

Current Valuation of the Company

No valuation is required

Other Consequences

Has downside protection in the form of debt that the Company repays the Consultant if the Company doesn’t raise the venture capital (but the ability of the Company to pay the if it fails is unlikely), the downside protection for the Company if the Consultants fails to deliver is through only issuing a small amount of value via the Convertible Note for small projects.

How to Issue Sweat Equity

The Sweat Equity process is best handled by issuing three types of agreements:

1. Complete one overall Sweat Equity Agreement for each consultant
2. Complete a separate Statement of Work (SOW) for each phase of work
3. Issue the sweat equity upon acceptance of deliverables

Step 1: The Sweat Equity Agreement

The Core Consulting Agreement Between a Company and a Contractor that is Contributing Sweat Equity.

What it is:

This agreement template is the starting point in our app and the starting point in the process for hiring a Consultant that is compensated with Sweat Equity. The Sweat Equity Agreement is the core consulting agreement that defines the relationship between the Company and Consultant and includes restrictive provisions, clarifies ownership of the contributed effort, and creates the flexibility to add Statements of Work and compensate in various forms of Sweat Equity

How it is used:

• A Company will need one Sweat Equity Agreement per individual Consultant.
• Our app will walk you through the step-by-step process of filling in all blocks of information, along with all of the necessary tips, instructions, and examples
• This agreement form will typically only take a couple of minutes to complete if you have the necessary inputs at hand
• Once you’ve completed the form, you can download and send to your attorney to review and/or sign online and send to the Consultant to review and sign
• All completed forms for all Sweat Equity Consultants that you complete are logged in your subscriber dashboard

Pro-Forma Sweat Equity Agreement Template

When you download our Sweat Equity kit, you’ll gain access to a number of templates, including a Sweat Equity Agreement template.

Our Sweat Equity Agreement template is a 12-page, comprehensive agreement that includes the following items:

1. Overall consulting agreement – this template has all of the necessary general legal language that governs the process of hiring a consultant (in most cases, a Sweat Equity contributor is an independent contract consultant and not an employee since the company has not yet launched).

2. Clear Company ownership of all deliverables – the agreement form makes it clear that the Consultant’s work is a “work for hire” and the Company owns all of the deliverables. This is often a major point of disagreement and conflict on handshake deals and bad “business divorces.”

3. Restrictive covenants – the agreement includes all of the necessary restrictive covenants, including clauses on proprietary information, non compete, non-solicit, and confidentiality. These are critical elements and our app allows you the flexibility to negotiate key terms such as the length of the non-compete period after the termination of the agreement, the non-compete territory, and a specific business description that is disallowed to protect the Company from the Consultant simply taking their work that the Company paid for down the road to another startup.

4. Dispute resolution provisions – the agreement also contains provisions on how to resolve any disputes that may arise.

5. Other general provisions – the template includes key provisions such as an indemnification clause and a limitation of liability to protect the Company.

Step 2: Statements of Work

The Project Agreement(s) Between a Company and a Consultant that Details Specific Deliverables for Each Phase of Work and Becomes Part of the Overall Sweat Equity Agreement

What it is:

This agreement template is the second step in our app when creating a best practice Sweat Equity Agreement and is used to clarify the specific deliverables of each small chunk of work, the value of that work, and how that work will be compensated (typically in a mix of both Cash and some form of Sweat Equity).

Each Statement of Work for a particular Consultant (we recommend using numerous statements of work to clearly define each specific deliverable for maximum clarity) become part of the overall Sweat Equity Agreement between the Company and the Consultant.

How it is used:

• A Company should use multiple SOWs per individual Consultant to maintain control of the deliverables and compensation to keep everything on track
• Our app will walk you through the step-by-step process of filling in all blocks
• This agreement form will typically only take a couple of minutes to complete if you have the necessary inputs at hand
• Once you’ve completed the form, you can download and send to your attorney to review and/or sign online and send to the Consultant to review and sign
• All completed forms for all Sweat Equity Consultants that you complete are logged in your subscriber dashboard

Pro-Forma Statement of Work Template

When you download our Sweat Equity kit, you’ll gain access to a number of templates, including a Statement of Work Template.

Our Statement of Work template is a 4-page agreement that is incorporated into the overall Sweat Equity Agreement and includes the following items:

1. Specific deliverables – this template contains the specific information for each deliverable, including the specific description and/or specifications of the deliverable, and the beginning date and estimated completion date.

2. Completion and Acceptance – the agreement form makes it clear that the Consultant’s work needs to be completed on time and to the Company’s satisfaction (often a massive issue with “loose” sweat equity arrangements that lead to disagreements and conflicts) and includes completion and acceptance criteria.

3. Termination and Dispute resolution provisions – the agreement also contains provisions on how to terminate the SOW in the event of the Consultant’s failure to deliver and how to resolve any disputes may arise.

4. Compensation – the SOW agreement form includes the necessary details on the amount of Cash compensation (typically it’s hard to find someone to work only for Sweat Equity) and timing of Cash compensation, as well as the amount of Sweat Equity compensation and the form of Sweat Equity (our app includes four popular forms of Sweat Equity, ranging from a Stock grant in the form of a Warrant, a Royalty, a Convertible Note, and a SAFE).

Step 3: The Agreement Issuing Equity

Once the consultant or co-founder has completed the deliverables defined in the Statement of Work, issue the Sweat Equity using one of the following agreements, as described in the Statement of Work:

a. Stock Warrant Agreement

b. Royalty Agreement

c. SAFE Agreement

d. Convertible Note Agreement

The following pages describe each of these agreements. To compare and contrast these types of Sweat Equity, please read the “6 Forms of Sweat Equity” section above.

a. Stock Warrant Agreement

The Agreement Between a Company and a Consultant that Grants the Consultant the Right to Purchase the Stock or Units of a Company

What it is:

This agreement template is one of the various forms of Sweat Equity that is built into our app and is incorporated into the Sweat Equity Agreement and a specific SOW that calls for all or part of the compensation for a specific deliverable by a Consultant to be compensated in the form of a stock warrant.

A stock warrant gives the Consultant the right, but not the obligation, to purchase equity at a specific price, called the “exercise” or “strike” price. Holding a warrant gives the Consultant the ability to purchase the stock at a certain price at any time in the future until the warrant expires. A warrant has significant tax advantages for the Consultant rather than simply issuing equity.

How it is used:

• A Company should use a Stock Warrant Agreement to issue equity to a Consultant to avoid adverse tax consequences when issuing equity in exchange for any work deliverables. If a Consultant is simply granted equity, then the value of the equity is immediately taxable in the form of personal income taxes at the time of issuance (typically at a time with the lowest probability of the future value of the equity).

However, if a Consultant receives a Stock Warrant (even with a very low exercise price), the issuance of the Warrant is not taxable and, if the Stock Warrant is exercised at least a year in advance of an exit event, the upside of the equity is taxed at capital gains tax rates and not personal income tax rates. (Be sure to seek competent legal and tax advice when choosing the various forms of Sweat Equity to avoid any negative consequences).

• Our app will walk you through the step-by-step process of filling in all blocks of information, along with all of the necessary tips, instructions, and examples

• This agreement form will typically only take a couple of minutes to complete if you have the necessary inputs at hand
• Once you’ve completed the form, you can download and send to your attorney and/or tax advisor to review and/or sign online and send to the Consultant to review and sign
• All completed forms for all Sweat Equity Consultants that you complete are logged in your subscriber dashboard

Pro-Forma Stock Warrant Template

When you download our Sweat Equity kit, you’ll gain access to a number of templates, including a Stock Warrant Template.

Our Stock Warrant template is a 10-page agreement that is incorporated into the overall Sweat Equity Agreement and SOW includes the following items:

1. Term and Exercise – this template contains the specific information for how the Stock Warrant is exercised, including a Net Issue or “Cashless” exercise and the overall term of the warrant.

2. Treatment of the Shares – the agreement form includes all of the necessary language on how the underlying equity is treated and the potential for dilution, stock splits, and reverse splits.

3. Shareholder Rights – the agreement also contains provisions on the rights of the Warrant holder before and after exercise and limitations on transfer of the Stock Warrant.

4. General Provisions – the Stock Warrant agreement includes the other required details regarding representations and warranties, securities notices, notice of exercise, and an assignment form.

b. Royalty Agreement

The Agreement Between a Company and a Consultant that Grants the Consultant the Right to a Revenue Royalty.

What it is:

This agreement template is one of the various forms of Sweat Equity that is built into our app and is incorporated into the Sweat Equity Agreement and a specific SOW that calls for all of part of the compensation for a specific deliverable by a Consultant to be compensated in the form of a revenue royalty.

A royalty agreement pays the Consultant a percentage of revenue in exchange for their contributed effort, rather than ownership in the Company.

How it is used:

• A Company should use a Royalty Agreement as a form of Sweat Equity compensation to tie a Consultant’s upside compensation directly to an app or product that the Consultant is developing. A Royalty Agreement allows the company to not only more directly tie the quality of the deliverable to success for the company, but a revenue royalty does not dilute the ownership of the company.However, since a royalty is paid out along the way, along with the revenue of the product the Consultant developed, there is an ongoing cash expense to pay down the royalty. Consultants will often prefer a royalty because they do not need to wait for an exit event in order to start realizing some compensation.A Royalty Agreement is non-taxable when issued, but is subject to personal income tax when paid. (Be sure to seek competent legal and tax advice when choosing the various forms of Sweat Equity to avoid any negative consequences).
• Our app will walk you through the step-by-step process of filling in all blocks of information, along with all of the necessary tips, instructions, and examples
• This agreement form will typically only take a couple of minutes to complete if you have the necessary inputs at hand
• Once you’ve completed the form, you can download and send to your attorney and/or tax advisor to review and/or sign online and send to the Consultant to review and sign
• All completed forms for all Sweat Equity Consultants that you complete are logged in your subscriber dashboard

Pro-Forma Royalty Agreement Template

When you download our Sweat Equity kit, you’ll gain access to a number of templates, including a Royalty Agreement Template.

Our Royalty Agreement template is a 6-page agreement that is incorporated into the overall Sweat Equity Agreement and SOW and includes the following items:

1. Basis and Amount of the Royalty – this template contains the specific information for how the Royalty is paid: the revenue it is tied to (all revenue, specific product revenue, the definition of net revenue, etc.), and the percentage of revenue that is paid, such as 5%.

2. Term and Timing of Payments – the agreement form includes all of the necessary language on the effective date, expiration date (no royalty should be committed to in perpetuity), and how often the payments will be calculated and paid (monthly, quarterly, or annually).

3. Payment Cap and Buyout – the agreement also contains provisions on the maximum payout cap (we strongly recommend that all royalties be capped at typical venture capital return rates – the average caps we’ve seen are 3x the Consultant contribution amount) and provisions for a buyout (we also recommend the ability to buyout the royalty with a payoff amount that is fair to both side (and that gives the Consultant a nice upside) in the event the Company needs to eliminate the royalty (such as in an exit event).

4. General Provisions – the Royalty Agreement includes the other required details regarding audit, inspection, and review rights that are common in royalty arrangements.

c. SAFE Agreement

The Agreement Between a Company and a Consultant that Grants the Consultant the Right to Convert Sweat Equity Contributions into Future Equity

What it is:

This agreement template is one of the various forms of Sweat Equity that is built into our app and is incorporated into the Sweat Equity Agreement and a specific SOW that calls for all of part of the compensation for a specific deliverable by a Consultant to be compensated in the form of a SAFE (Simple Agreement for Future Equity).

A SAFE documents the negotiated value of the Consultant’s contributed effort that will be converted into the same equity that the investor gets in a future venture capital investment round.

How it is used:

• A Company should use a SAFE to issue equity to a Consultant to avoid adverse tax consequences when issuing equity in exchange for any work deliverables. If a Consultant is simply granted equity, then the value of the equity is immediately taxable in the form of personal income taxes at the time of issuance (typically at a time with the lowest probability of the future value of the equity).However, if a Consultant receives a SAFE, the value of the amount of contribution by the Consultant that is compensated in the form of a SAFE is not taxable at the time of issuance, but is taxable when and if the Company receives a venture capital investment (typically a sign of success and the ability to launch) that triggers the conversion of the SAFE into equity in the Company.Using a SAFE, therefore, helps the Consultant manage the tax impact and risk premium for better alignment of risk/reward. The SAFE form assumes the Consultant is an accredited investor and understands the risk of investing their time in a SAFE. (Be sure to seek competent legal and tax advice when choosing the amount of the various forms of Sweat Equity to avoid any negative consequences).

• Our app will walk you through the step-by-step process of filling in all blocks of information, along with all of the necessary tips, instructions, and examples This agreement form will typically only take a couple of minutes to complete if you have the necessary inputs at hand

• Once you’ve completed the form, you can download and send to your attorney and/or tax advisor to review and/or sign online and send to the Consultant to review and sign
• All completed forms for all Sweat Equity Consultants that you complete are logged in your subscriber dashboard

Pro-Forma SAFE Agreement Template

When you download our Sweat Equity kit, you’ll gain access to a number of templates, including a SAFE Agreement Template.

Our SAFE template is an 8-page agreement that is incorporated into the overall Sweat Equity Agreement and SOW and includes the following items:

1. Conversion Rights – this template contains the specific language for how the amount of the SAFE (the value of the Consultant’s time contribution) is converted into a venture capital investment round and into the same securities as the venture capital investor.

2. Conversion Terms – the agreement form includes the Conversion Cap (the maximum valuation of the investment as further described in our in-app instructions) and Discount Rate (the discounted price paid for the securities as further described in our in-app instructions).

3. General Provisions – the SAFE form includes the other required details regarding representations and securities notices.

d. Convertible Note Agreement

The Agreement Between a Company and a Consultant that Grants the Consultant a Note and the Right to Convert the Note into Future Equity

What it is:

This agreement template is one of the various forms of Sweat Equity that is built into our app and is incorporated into the Sweat Equity Agreement and a specific SOW that calls for all of part of the compensation for a specific deliverable by a Consultant to be compensated in the form of a Convertible Note. A convertible note documents the negotiated value of the Consultant’s contributed effort that is owed to them by the Company unless it is converted into the same equity that the investor gets in a future venture capital investment round.

How it is used:

• A Company should use a Convertible Note to compensate a Consultant for work deliverables when the goal is to delay the payment of cash compensation while giving the Consultant the opportunity to convert the Note to equity upon a venture capital investment (typically a sign of success and the ability to launch) that triggers the conversion of the Convertible Note into equity in the Company. (Be sure to seek competent legal and tax advice when choosing the amount of the various forms of Sweat Equity to avoid any negative consequences).

• Our app will walk you through the step-by-step process of filling in all blocks of information, along with all of the necessary tips, instructions, and examples
• This agreement form will typically only take a couple of minutes to complete if you have the necessary inputs at hand
• Once you’ve completed the form, you can download and send to your attorney and/or tax advisor to review and/or sign online and send to the Consultant to review and sign

• All completed forms for all Sweat Equity Consultants that you complete are logged in your subscriber dashboard

Pro-Forma Convertible Note Template

When you download our Sweat Equity kit, you’ll gain access to a number of templates, including a Convertible Note Template.

Our Convertible Note template is a 5-page agreement that is incorporated into the overall Sweat Equity Agreement and SOW and includes the following items:

1. Principal and Interest – this template contains the specific language for how the amount of the Note (the value of the Consultant’s time contribution) will be repaid and the applicable interest rate on the Note.

2. Conversion Rights – the Convertible Note agreement also contains the specific language for how the amount of the Note and Interest is converted into a qualifying venture capital investment round (including the minimum raise amount that triggers the conversion and the additional equity issued to pay off the interest). The Note provides the Consultant at conversion with the same securities as the venture capital investor.

3. General Provisions – the agreement form includes the other required details regarding default provisions and transferability.

5 Secrets for How to Avoid the Biggest Sweat Equity Mistakes

It happens all too often. In the excitement of the early days of a startup, the founder offers equity to a key hire or contractor. Often it’s a key player that is promised the coveted status of “co-founder”, such as the developer that is believed to be able to build out the company’s tech vision as the CTO. There’s a promise of x% of the company.

The amount is usually too much. There’s no money for attorneys and there’s little time to document the arrangement, but the excitement and expectations are high: the founder/CEO is confident that funding is imminent and the co-founder CTO is confident that the tech will be built in only a few months. Meanwhile, what gets lodged in the indelible memory of the co-founder is the x% of ownership that was promised and little thought is given to the eventual dilution from other employee equity grants, advisor warrants, seed funding, venture capital funding, etc.

Then come the unmet expectations: the funding doesn’t come through as hoped, patience is strained, tempers flare and the tech platform stretches on interminably without the necessary funding for a tech team or it simply doesn’t deliver. In a huff, the founder/CEO fires the CTO after only x number of months. But what about the promised equity? The company still lacks a formal options plan (which was going to be put in place after funding), so nothing ever got documented.

The CTO “lawyers up” and demands to see the evidence of his stock grant. The company hires counsel and is asked if the CTO was on a vesting schedule or if there was a documented specification for the tech platform and if the promised equity was contingent upon the successful delivery of the platform. The CTO claims ownership of the software he developed, which dooms any hope of ever raising capital for the startup.

Regret and frustration and legal bills mount. The distractions build, morale plummets, and another tech startup bites the dust.

So what’s the answer to avoid this tech startup doom loop?

1. Establish very clear goals and deliverables: instead of “boiling the ocean” and expecting or promising to create an entire app, stick to smaller chunks of work one phase at a time such as creating a wireframe or writing a requirements document

2. Develop one, overall agreement that establishes how you will work together, who owns the deliverables, how disputes will be handled, etc.

3. Create a separate, specific Statement of Work (SOW) for each of those chunks of work with very clear deliverables, payment terms, and acceptance criteria in various forms and combinations of Cash and Sweat Equity

4. Grant Sweat Equity along the way in exchange for successful deliverables

5. Use iron-clad “battle-tested” thorough legal documents to protect both sides

Conclusion

Having lived with the consequences of both granting and receiving sweat equity (and having seen lots of startup horror stories involving contentious ownership fights), our app and agreement templates were developed through a collaborative effort of entrepreneurs and attorneys to develop sweat equity agreement templates that incorporate all of the necessary terms to protect both the startup founder that issues sweat equity, and the startup consultant or advisor that works for sweat equity.

Importantly, our agreements are designed to successfully set up the next stage of a startup launch and fly through the venture capital due diligence process, since nothing will kill a potential investment quicker than a sloppy or vague ownership structure without the proper legal documentation and protections.