New Venture Lab: Equipping Christian Entrepreneurs

Question

How should I think about granting someone "sweat equity" in my business?  Should I grant them stock or give them a royalty?  Any suggestions?

Answer

Granting equity or a royalty in exchange for services rendered can be a creative and effective way to further your opportunity with limited capital. The considerations include how you value your business, how you value the other party's sweat equity and how you pay out the value for that sweat equity.

1. How you value your business - both parties need to agree to the value of the business because that is a big part of the equation of the sweat equity. Most startup businesses with nothing more than a business plan are valued in the $500k to $2m range as a broad estimate, but can certainly be higher or lower. You can also learn more about how a business is valued here. The main point is that this is a point of discussion, negotiation and agreement between the two parties.
2. How you value the time of the contributing party - both parties need to agree to the value of the party that is contributing time in exchange for the sweat equity. I would suggest using a market rate for the skill set they are contributing or the work being performed. Let's say that you want to hire an attorney to consult with you on Intellectual Property matters and his normal rate is $400 per hour. That is the market rate that you should use to calculate the value of his time. The more the contributing party shares in the venture's risk, the more of a "risk premium" they should get. For example, let's say the attorney mentioned above spent 20 hours helping you to file a patent and did it in exchange for a revenue royalty. While the market value of his contribution is $8,000 in cash ($400 per hour X 20 hours), if he is going to risk that contribution on your venture and wait patiently for a potential royalty to get paid, it is fair in my opinion that his royalty agreement is capped at $16,000 or 2X his contribution to reward him for the risk. Therefore, the "risk premium" is $8,000.
3. How the value will be paid - both parties need to agree on how the value will be exchanged. The contributing party might receive cash, stock (which is taxable upon receipt), options (which is taxable once exercised), a revenue royalty, or some combination of any of those or other compensation forms. Let's say the attorney mentioned above does the IP work for $200 per hour plus a royalty of 5% capped at $8,000. Since he got 50% of his market value in cash, there is no need for a risk premium on that amount, but since he is risking $4,000, it is fair that he gets a 2X risk premium and therefore the royalty amount is up to $8,000.

Other key points:

• Be sure to memorialize the royalty agreement in writing to avoid any miscommunication (download a royalty agreement kit)
• Be sure to get good tax and legal counsel to understand all of the consequences of the deal
• The agreement should present a good and fair opportunity to both parties
• Beware of any "yoking" concerns by partnering with someone in this manner