Sweat equity explained: how to pay key people with shares instead of cash (UK)

Sweat equity is how a company pays for talent with shares instead of cash. Maybe you are an employee who has been offered shares in the business you work for, or maybe you are a business owner who wants to incentivise and retain key people without a bigger payroll. Either way, sweat equity can work well for both sides, provided it is valued sensibly, structured properly and written down. Here is what it is, how it works in practice and what a sweat equity agreement needs to cover.

What is sweat equity?

In short, sweat equity is buying shares through hard work and effort rather than with money. The person contributes time, skills and effort, and in return they receive shares, ownership in the company.

This kind of arrangement is a natural fit for business ventures where one partner brings the money and the other brings the sweat, the expertise. Tech companies in particular love using sweat equity. A developer codes for equity. A marketer grows the business in return for shares. When the company does well, everyone wins.

How does sweat equity work in practice?

If you are the business owner, the first thing to do is put a value on the skills, effort or outcome you want from that key person.

One way to do it is to benchmark against the open market. If you went out and hired a consultant to deliver the same outcome, how much would you have to pay them? That figure is the value of the work. You then work out how many shares in your company equate to that value, and that is the size of the grant.

That is just one way to do it, and it is the way I would want to do it. There is no right or wrong way and no legally mandated method. The point is to have a defensible basis for the number of shares rather than plucking a percentage out of the air.

Once you have a figure, you detail the arrangement in a sweat equity agreement. In practice that is usually something like a share option plan between the company and the relevant employee, rather than an immediate issue of shares.

Share options and tax on sweat equity

Before you grant anything, speak to the company's accountant. Where shares form part of the remuneration an employee receives in return for their services, there might be tax liabilities or exposure for the company. You want to be very careful about that aspect and get advice on how to comply with the relevant rules before the shares or options are granted, not after.

This is also one of the reasons sweat equity is often structured as an option to buy shares at a future date rather than shares handed over on day one. The option approach lets the company tie the shares to continued service or to results, which I cover below.

Sweat equity agreement: share classes and articles

The first thing the agreement needs to specify is the kind of share the employee is being offered the option to buy.

It is very possible that your company has, or should have, different classes of shares: one for the founders, one for investors and one for key employees. If you do have different classes, the agreement must say which class the employee is buying, because the rights attached to each class differ.

If your company does not have different classes of shares, you should strongly consider creating them. That means adopting bespoke articles of association that set out the different classes, and the rights, obligations and restrictions that apply to the shareholders of each class. Founders usually want to keep control and certain economic rights for themselves, and the articles are where that is done. See how to create different classes of shares for the mechanics.

Setting the share option price

The second thing to specify is how much the employee will pay to buy the shares.

Typically the way it works is that the company gives the employee the option to buy a specific number of shares at a specific price. The reason this is so attractive to employees is that the price is usually far below what an investor would pay. It is typically either:

• A nominal amount, for example £1 per share, when an investor would be paying something like £1,000 per share; or
• A greatly reduced price, for example £500 per share instead of the £1,000 an investor pays.

The gap between the option price and the investor price is where the value of the sweat equity sits. The employee is effectively being paid in the discount.

Vesting schedules and KPI milestones

The third thing the agreement needs to detail is what has to happen before the employee can exercise their option to buy shares. There are two common approaches, and they can be combined.

• Time-based vesting. The employee has to stay with the company for a set period, for example at least three years, before they can exercise an option. After that, they might get a further option to buy shares in each following year.
• KPI milestones. The option becomes exercisable when the employee hits specific targets. If you have a salesperson you want to incentivise, you might say: bring in £3 million in sales revenue and you can buy X number of shares. Or if someone goes out and raises a certain amount of money from the lending market, they get a certain number of shares. Any milestone that matters to the business can work.

Shares in your company become a form of money. You are effectively printing money every time you print share certificates and using them as consideration for value from key people. The warning is the same as with real money: the more you print, the more it dilutes. Just as more money in the economy makes things cost more, the more shares in issue, the more shares you need to hand over to deliver the same value to someone. Keep an eye on the total you are committing across all your sweat equity arrangements.

How to exercise share options

Lastly, the agreement needs to set out the practical system for the employee to exercise their option. This is the logistical part and it can be simple.

• Notice. The employee gives the company notice at the relevant time that they are exercising their option.
• Compliance. The company must comply with that notice and issue the shares to the employee.

Spelling this out avoids arguments later about whether an option was validly exercised and when the shares should have been issued.

That is how sweat equity lets a company incentivise and retain key employees while receiving real value, and pay for that value with shares rather than cash.

Next steps

If you are a business owner, start by valuing the outcome you want and translating it into a number of shares, then speak to your accountant about the tax position before you offer anything. Check whether your articles of association need updating to create a separate class of shares for employees, and have a corporate solicitor draft the option agreement with the price, vesting conditions and exercise mechanics written down. If you are the employee being offered sweat equity, ask for exactly those terms in writing before you start working for shares.