Sweat equity comes to the rescue of those early-stage startups which cannot afford to attract the right talent. Sweat equity is assigned to an employee or sometimes even a co-founder who brings certain skills and expertise on board. However, drafting sweat equity agreements is a tricky business. Why would someone stay on for a longer time period, if they got all their equity in the first year itself? Is there a guarantee that the person would perform to the desired expectations even after getting the equity? These are just few of the questions which trouble early-stage startups when they think of issuing sweat equity shares. Most founders commit common mistakes such as not providing a vesting period or not including limits on the number or percentage of equity shares. These mistakes may seem trivial but have long-standing consequences for the start-up.
Let us see what are these five common mistakes which you should avoid while drafting a sweat equity agreement.
1. Unrestricted Amount of Equity
One cannot assign unlimited equity to an employee, no matter how much expertise they possess. Hence, it is pertinent to place a limit on the amount of sweat equity which may be issued. For instance, a limit of 10% may be placed. This 10% of equity may be given to the employee based upon the achievement of certain milestones and may be spread over a longer period of time.
2. No Vesting Period
Vesting period means the time period for which an individual contributor will have to wait before he/she starts getting a share in the equity. In the absence of the same, an employee would not have any incentive to stay back. Hence, equity should be vested in a staggered manner over a period of tie. The vesting period clause is a necessary part of a sweat equity agreement. It is required to build the company’s trust and reliance on the individual and the individual’s interest in the company.
3. No Milestones
Have set milestones to ensure that the employee is performing well. You can also link the issue of equity to these milestones. Milestones refer to the specific achievements which must be reached in order to get equity. Milestones are determined in order to ensure that the employee who is receiving the equity performs to the desired expectation levels. The milestone clause seeks to serve similar purpose as that of vesting period. It tests the commitment and value addition done by an individual and therefore helps in fairly deciding who actually deserves to get a share in the equity.
4. Absence of a Performance Criteria
As sweat equity agreements seek to pay for the intangible contributions of individuals it is necessary that the scope of their contributions is clearly defined. Clearly defining the performance criteria becomes very important here. Failing to have clarity on the same could unduly benefit and harm any of the parties depending upon the situation. A clearly defined performance criteria ensures that the employee does not spend his/her sweat (labour and intellect) on those tasks for which he/she would not be getting a share and that the employer does not have to pay in equity for the work which he/she either doesn’t want a specific employee to perform at all or considers it as a part of some work which has already been decided to be paid.
5. No Termination/Exit Clause
Proper exit/termination clauses should be outlined in the sweat equity agreement. Events of default such as the employee not meeting the laid down performance criteria or the employee breaching company policies etc. should be mentioned as grounds of termination. Remember the employee would also be a shareholder in the company and hence, make the exit process smooth. Moreover, there should be an understanding that the shares which have not yet vested would lapse on the termination.
Drafting a sweat equity agreement is not an easy task as many considerations need to be taken into account. It is advisable that legal help be taken for the same. We at LexStart have advised many early-stage start-ups in attracting the right talent by drafting their sweat equity agreements. If you need any assistance from us, our team of highly qualified lawyers is always ready to help. You can write to us at support@lexstart.com and a member of our team would reach out to you to clarify all your queries.