Getting a start-up off the ground isn’t easy. It is also hard to keep a good team around and secure new talents especially when you’re bootstrapped with limited cash. Sweat equity shares are a powerful tool for helping you retain talents, and even get others like advisors and mentors in the ecosystem or industry that can add long term value to your entrepreneurial journey as a start-up founder.
The common mistake
A lot of start-up founders like to offer or issue a fixed upfront percentage of shares in your business when offering shares to a potential hire.
Generally using a percentage isn’t a bad idea, to begin with. The challenge with using a fixed percentage is tied to the valuation. Your 10% equity in your business may be worth a lot more in six months time or even in twelve months time. To summarise, the 10% may be worth differently as the start-up grows (assuming the value of the company goes up of course).
In other words, it may be worth the hassle to actually calculate or quantify the value of the work that will be done by the person that you’re onboarding in your start-up.
How to issue sweat equity
So my preferred option is for you to calculate the value of the work that the talent is bringing into the company.
Let’s say you need to get a landing page with a nice catchy ‘call to action’ button done for your start-up.
You’ve asked around and found that the average cost of hiring a web designer is around RM5,000 for a decent working landing page I can offer the web designer shares worth RM5,000 in my venture so long as the work is completed. The agreement can be set out in a simple developer agreement with the scope and the fee will be paid by the issuance of the shares from your start-up instead.
The usual challenges when issuing sweat equity
In practice, many company secretaries in Malaysia may not be familiar with the sweat equity concept and don’t be surprised that you may end up having a flat “no” when you told your secretary that you want to give out some shares to a CTO or a business development person in your business.
Once you place out shares to a person, you should immediately get a start-up lawyer to prepare a shareholders agreement in place setting out the rights and obligations between the existing shareholders including the new person that has received shares in your start-up.
Also, the company secretary will need to prepare the paperwork including a board resolution for approving the allotment and issuance of new shares to the sweat equity shareholder and the issue price.
The rights of a sweat equity holder as a shareholder
As far as the companies law is concerned, a sweat equity shareholder has the same rights and duties as other existing shareholders. As a shareholder, the sweat equity holder will be entitled to the waiver of the pre-emptive right (also known as the right of first refusal) when it comes to the new issuance of shares in the future by the company. This also includes any transfer of shares by any existing shareholder (usually by an existing co-founder).
In practice, it may be possible to incorporate a clause in the shareholder’s agreement that the sweat equity shareholder agrees to waive his pre-emptive right in the future (generally, every shareholder should be entitled to this pre-emptive waiver right as a matter of practice). So if you want to issue shares to anyone, make sure you put things in writing so that everyone is on the page when it comes to the respective rights and obligations. This also includes other clauses such as co-sale obligations, tag-along rights and drag-along rights and so on.
I have found crowdfunding investors in most equity crowdfunding campaigns agree to waive their pre-emptive rights to subscribe for new shares if the issuer i.e. the company raises new funds in a new equity crowdfunding campaign. This may be included inside the shareholders’ agreement to avoid the logistics nightmare of getting every single crowdfunding investor to sign off on their respective waivers every time a company wants to raise new funds.
Make sure that you get a good start-up lawyer to help you navigate the usual challenges in coming up with the offer letter and the necessary agreements to ensure that the shares are issued correctly by the company.