Summary
- Sweat equity allows startups to compensate employees and directors with shares or share options instead of cash, making them part-owners of the business.
- Shares grant immediate shareholder rights, including voting and dividends, whilst options only grant rights once exercised.
- Businesses can issue different classes of shares to control the rights employees receive, and shareholder agreements can restrict share transfers or set out exit provisions.
- This article is a plain-English guide to sweat equity for Australian business owners, covering the key legal implications of issuing shares or options to employees and directors.
- It has been produced by LegalVision, a commercial law firm that specialises in advising clients on startup and equity matters.
Tips for Businesses
Consider a shareholder agreement from the outset to control share transfers and departing employee obligations. Issue a separate class of shares to limit voting rights. Be aware that shares are taxable as employment-related securities. If preserving cash flow is a priority, options may suit your business better than direct share issuance.
As a business owner, you may come across the phrase “sweat equity”, and scratch your head, wondering what exactly it is. This article will define the term and explain the legal implications behind sweat equity.
Overview
Sweat equity is a term business owners and investors use to describe a special kind of compensation. This is where a startup business gives its employees and directors shares (or the option to purchase shares) in the company.
Generally, if you give someone “equity” in your company, they have immediate rights as a shareholder in the business. In other words, they will be owners of the business. This means they can:
- vote at shareholder meetings;
- be paid their share of dividends if a dividend is declared; and
- receive their portion of the company’s assets if it is wound up.
On the other hand, options give them the right to acquire equity in the company later. Until they exercise this option, they will not have any rights in the company.
We will now consider the implications of both in more detail.
Equity Shares
Transferring Existing Shares vs Issuing New Shares
If you grant another person, including an employee, shares in your company, your ownership will be diluted. How this dilution takes place depends on whether you transfer existing shares or create new ones.
If you transfer existing shares you own to your employee(s), you will have fewer shares. However, the total number of shares in existence does not change.
In comparison, if you issue new shares, the value of any shares you hold will be worth less.
Shareholder Rights
Shareholders have certain rights in the company, and you must protect these rights. Otherwise, they can have a claim against the company (or its directors).
Most importantly, shareholders will usually have the right to vote in shareholder meetings involving essential company decisions. These include issuing new shares or amending the company’s articles of association.
They will also have the right to be paid a dividend if a dividend is declared. That means that if you want to pay yourself a dividend and there are other shareholders, you must pay them as well.
Classes of Shares
You can attach or modify the rights attached to the shares. For instance, you may want to remove the rights to participate in shareholder meetings and entitle the shareholders to dividend payments if and when they are made. These kinds of shares are known as non-participating shares.
Alternatively, you may want to ensure that you and the other founding shareholders receive the first rights to dividend payments. You would effectively create preference shares for you and the other founding shareholders and then issue another class of shares (you can call them “B shares”).
Tax Implications
Shares fall under taxable income, specifically “employment-related securities”. Therefore, the employee will need to pay taxes on the value of the shares. Of course, this depends on the company’s value.
Purchase Price
You are free to sell the shares to your employees or directors at a specific price. For instance, you may not be keen to give away the shares.
Shareholder Agreements
A shareholder agreement can create certain obligations between shareholders that are separate from any rights they have in the company as a shareholder. In other words, this is a private agreement between the shareholders that will not create any rights or obligations in the company but can be an effective way to specify important things, such as:
restrictions on the right of shareholders to transfer their shares;
promises not to compete with the businesses; and
agreements about how any future dispute will be resolved.
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Options
Share options in sweat equity refer to an agreement between the company and the employees that entitles the employee to acquire or purchase shares later or after a particular event. If the employee elects to exercise this option, the company must honour their side of the agreement.
Examples of how options shares can be structured include:
- the option to acquire the shares after a certain period of employment, such as two years; and
- if the company goes public, the option to acquire shares for a fixed price before the public offering.
The shares the employees will have the option of acquiring can be structured as you wish.
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Vesting Schedules
Most companies attach a vesting schedule to sweat equity shares or options. This means employees earn their shares gradually over time, rather than receiving them all at once.
For example, a four-year vesting schedule might release 25% of the shares each year. If an employee leaves after one year, they only keep the shares they have already earned.
Vesting schedules protect the business. They ensure employees stay long enough to genuinely contribute before receiving their full equity entitlement.
You can also include a “cliff” period. This means no shares vest at all until the employee reaches a minimum period of service, such as 12 months. After the cliff, vesting continues on a regular schedule.
Including vesting terms in your shareholder agreement or option deed keeps everything legally clear from the start.
Key Takeaways
If you are looking for ways to attract top talent to your startup business, providing “sweat equity shares” as part of your employees’ benefits package can be a great way to motivate their performance. This is because they will have a share of ownership in the company. Therefore, the value of their shares will be tied to their performance and the company’s performance as a whole.
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Frequently Asked Questions
Sweat equity describes shares or options startups provide their employees to attract and retain talent.
If you permit employees to acquire shares in your company, they will effectively own a portion of the company. This means that, subject to the rights attached to the shares, they will share in the company’s profits and can vote at shareholder meetings. You can disapply these rights by issuing your employees shares of a different class to the shares you and the other founders own.
Shareholders can typically transfer shares, but a shareholder agreement can restrict this right, preventing employees from selling to outside parties without approval.
A shareholder agreement can include provisions requiring departing employees to sell their shares back to the company or remaining shareholders.
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