One of the barriers some potential business investors face is the need for upfront capital with which to invest. Many potential owners or partners believe in a business concept and want to contribute to its success but lack the funds to invest upfront. For these would-be owners, a structured "sweat equity" position allows them to earn partial ownership of the business with their labor invested over time. Accepting labor in place of capital allows a business to benefit from the investor's knowledge and efforts while also allowing the laborer to share gradually in the business's ownership.
Value the Business
Calculate a total value for the business based on the capital or assets invested in the business. For example, if investors have provided $200,000 in capital and equipment worth $100,000, the business’s total value would be $300,000. For businesses already operating, you could also base the value of the business on the business’s expected income over the next three to five years.
Set Equity Limits
Determine the total amount of equity (or ownership) that may be earned via the structured sweat equity position. Some two-person partnerships may allow up to 50 percent of the company to be earned via sweat equity while businesses with multiple investors may limit the amount of sweat equity that can be earned to an amount equal to the other investors’ stake in the business.
Establish a Fair Labor Rate
Set the rate at which the labor invested will accrue toward equity in the business. For many businesses, this means simply determining the sweat equity partner’s salary or hourly pay rate and then applying that rate to their ownership stake as hours are worked. For example, a sweat equity employee who worked 40 hours at a rate of $10 per hour would have earned $400 in equity capital in the business.
Select a Vesting Period
Decide whether your sweat equity agreement will include a “vesting” period, i.e., a time that must transpire before the employee’s sweat equity is converted to ownership equity. For example, the business may have a sweat equity partner whose equity is only converted, or “vests,” after six months. Vesting provisions help to prevent workers from leaving a business before their sweat equity has been fully converted into ownership equity.
Write a Contract
Write a basic contract that includes all of the provisions above. Specify exactly how much equity will be accredited to the sweat equity partner for each hour (or week or month) of labor provided. Note any minimum or maximum equity earning limits you’ve decided upon, along with any vesting period you may have decided to impose on the position.
Be sure to specify exactly when the sweat equity is converted to ownership equity (be it monthly, semi-annually, annually or over any other period of time) since the ownership stake may determine voting rights, profit sharing and other legalities of business ownership.
Sign and Notarize the Deal
Take two (or more) copies of the contract to a bank or other institution with a notary public and have all interested parties sign each copy of the contract, allowing the notary to witness each signature. Each participant will be required to provide photo ID prior to signing the documents. After signing, both parties should retain their own copies of the contract for future reference.
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