Before you Sign the Dotted Line: Considerations regarding "sweat equity" agreements

Here at Smith Shapourian Mignano PC, some startups inquire whether they should issue equity to service providers such as engineering firms or mobile application developpers, in exchange for the latter’s services; and ask us about the kinds of issues that they should discuss with these service providers prior to having us draft up a “sweat equity agreement.”  To that end, we provide this informative blog post on the topic.

First of all, if you are a startup considering entering into this type of arrangement with a service provider, please note that most startups only consider this option if: (1) they cannot get the funds from a traditional investor so as to pay for the contemplated work; (2) the cost of execution of the work is significant; (3) they consider the service provider a long-term strategic partner; and of course, (4) whatever cash savings they are realizing in this arrangement are invested at a reasonable company valuation.   

All that aside, before entering into the “sweat equity agreement,” you and the service provider will need to discuss the below topics, among others:

1. Is the service provider expecting common or preferred stock?  

2. Is the service provider expecting voting rights, or can you give them non-voting stock?  If they are expecting voting rights, can these rights be capped at their pro rata ownership in the company?

3. Is the service provider requesting to fill any seats on your board of directors?  

4. What have you discussed with the service provider as far as: (1) inclusions and exclusons in their scope of services; (2) timeline for deliverables; and (3) staying within the "budget" estimates that they provide you, so that there is no surprise requests for additional equity?  

5. What happens if you do not like their work product, or they just stop working all together because they no longer believe in your startup?  Have you discussed what happens in the event of early termination, and how and where you will resolve disputes over the scope of services or equity?

6. Have you agreed to give the service provider a certain amount of equity in exchange for different projects, or based on the work performed in phases?  

7. Once the equity is granted, will it vest all at once or vest over time?  Most founders receive their shares in the 4:1 vesting schedule. Are there ownership concerns if the service provider is subject to no vesting, or a different vesting schedule?  

8. Do you see this as a partnership?  Are there other legal structures or routes (i.e., contractual or entity-based joint ventures, profits-sharing arrangements, etc.) to consider at this time, in lieu of the sweat equity agreement?

Finally, the service provider is an investor in this situation.  So, as with any investor, you, as the startup, should not promise or indicate any certainty about your chances of a later financing round, potential buyers, or future valuation expectations.  The service provideer must make its own assumptions and reach its own conclusions, after performing its own due diligence, about the investment.

Smith Shapourian Mignano PC is available to answer any questions or concerns you may have regarding a sweat equity arranagements with third-party service providers.

This blog does not constitute solicitation or provision of legal advice, and does not establish an attorney-client relationship. This blog should not be used as a substitute for obtaining legal advice from an attorney licensed or authorized to practice in your jurisdiction. You should always consult a suitably qualified attorney regarding any specific legal problem or matter in a timely manner, as statutes of limitations may bar your claim.