Let me start with the caveat that I am not a lawyer and you should not construe this article as legal advice and you should seek legal counsel on all matters of corporate governance and taxes. In addition the laws may be different from state to state so do your research and consult an appropriately licensed expert.
So last we left off we were trying to figure out just how a sweat equity partner earns their share of the business...
Let's set something straight first that is often mistaken by most investors and equity partners. Sweat Equity in its purest sense is intended to compensate someone for the "sweat" or work they perform. You can't actually earn Sweat Equity if you are getting paid a salary or some form of guaranteed payment or distribution from the partnership. Especially if the money to pay for the sweat is coming from the other partners's cash investment. Sweat creates value in the absence of cash, the value is the work. The theory is, that you can choose to be an employee and be paid for your work in cash or choose to be an owner and get paid for your work in the form of equity in the business. The practicality is that sweat equity partners almost always get some form of compensation to live and survive. They key is for how long if the business is losing money during start-up.
The investment cash is akin to adding fuel to a fire to exploit the work so money can be made. If you are a partner with no cash investment earning a salary or distribution, you aren't getting sweat equity you are getting a bonus or gift of equity as you are presumably being paid a fair market rate for the work you are putting in. If your fair market rate is $40,000 per year and you are earning cash income of$20,000, then it may make some sense to be given $20,000 in sweat equity value to close that gap but otherwise if you are earning a fair salary you are no longer getting sweat equity but rather a bonus of some sort.
Note to founders seeking investment and promising sweat equity to their investors: DO NOT promise 80 hour weeks with no pay if you can't afford to do this for several years or at least twice the amount of time your plan shows it will take to reach profitability or you may wind up with no role and no equity. If you don't fulfill your end of the contract you are in breach and may be at risk of losing your equity. Additionally the commitment is always underestimated by both sides. You won't win any parent of the year awards while building a business and putting in 80 hours a week. Choices in life are a trade-off and you can only do the best you can.
Sweat equity and any equity for that matter that is awarded to a partner is potentially taxable. CONSULT A QUALIFIED TAX ACCOUNTANT OR LAWYER to understand the best way to minimize your tax situation.
So that being said, let's caveat all this with a little bit of tax education but realize you really should consult a tax accountant and not rely on advice you see on the Internet as your situation may have specifics not covered here...
Before a company is incorporated, or at its inception of incorporation, generally the company may distribute equity to the founders in any way without incurring a tax liability. This usually applies to both corporations and partnerships. LLC's are normally construed to be a partnership. The IRS allows this as they deem the company to be worthless at this point, so receiving an interest in a valueless asset is not a taxable transaction or event. Thus, founders receiving sweat equity can avoid any tax liability early on.
After the company is incorporated, things aren't so simple. If a founder receives sweat equity after the company has been incorporated, the partner receiving sweat equity must pay taxes on the value of the equity they receive. There are ways to reduce this burden but that is beyond the scope of this article.
The difficult problem in start-ups is that the value of the equity is often financially calculated at $0 for book or tax purposes meaning the value of the equity you receive is not taxable as it is worthless as the business still needs to be built, capital contributed and revenue and profits still need to be generated. These are all big risks recognized by savvy investors and the IRS alike which is why this practice is allowed to happen with no taxable income to the sweat equity partner. Let me repeat this point, the value of your business is $0, it is deemed worthless. This makes sense since the value may never be achieved given that the majority of most new businesses will fail. Now think about how the financial investor feels about putting down $250,000 in a company the IRS has deemed worthless right now.
So getting back to how we determine what or how the sweat equity partners gets their shares...
Does the sweat equity partner get their equity day 1 that they walk into the partnership? Do they have to earn their equity? Is there a vesting period to earn their equity and if so how long must they have to work before their equity is vested and they become part of the ownership of the business?
There are 3 basic ways a Sweat Equity Partner can obtain their shares in the business:
- All of the equity is given to the Sweat Equity Partner upfront on day 1
- The Sweat Equity Partner must earn their equity over time or upon hitting certain financial and or operational goals
- The Sweat Equity Partner is awarded Stock Options to purchase their stock upon some future event
Each one of the above scenarios has differing legal and tax implications so you need to seek qualified advice to see how to optimize your outcome in these situations.
So let's take an example from No. 1 which is commonly found in partnerships with novice investor groups, friends, or family members but rarely found with savvy or experienced financial investors unless there is enormous trust among the partners. Normally all of the equity isn't granted upfront but vested over time to insure the sweat is put in. Friends and family may not care but experienced investors looking to get a return and mitigate their risk do. If you are a sweat equity partner with this type of deal consider yourself fortunate. If you are a partner who has vested all the equity up front to your sweat equity partner then you need to mitigate your risk in other ways.
Example No. 2 is the more professional and fair way for the sweat equity partner to obtain their interests in the company. It insures a level of commitment that must be put in and allows the partner to earn their way mitigating the risk to the financial partner who has to pay for their equity all upfront.
Example No. 3 is found more often in larger corporations and or as a part of an entire compensation package and not as a sweat equity deal in which the Sweat Equity Partner is not expected to receive any cash compensation. Stock options may be used to attract talent to a risky start-up by offering an executive a compensation bonus of 1-5%. It serves as a great way to incentivize a management team or a advisory board.
If that sweat percentage is 50%, we could make a case that the sweat equity investor must work until the original $250,000 cash investment is paid back by either generating income for the partnership or putting in some predetermined amount of work and time as a requisite before they are allowed to pull any money from the partnership.
Deference has to always be given to the capital investor's primary interest. Under normal circumstances, the primary goal is to not lose the money invested and waste the many years they worked to earn it and to try and get a return on the investment. Plain and simple. Any combination that gets to a repayment of capital to the financial partner and gives them a reasonable return for the risk and time value of the investment is fair for everyone. The only problem in my experience, is that when things don't go as planned, the sweat equity partner is the first to either bail on the company or hold the financial investor hostage in some way.