Businesses beware the pitfalls of sweat equity

This can be an easy win for companies that are tight for cash, but it can give rise to problems, if it is not properly thought through. 

What is meant by sweat equity? Sweat equity is a clever method used to exchange your shares in the company to pay for products, services or expertise from suppliers, key employees and contractors. It kills two birds with one stone: by paying for services in sweat equity the company has raised investment from its suppliers, and it owes nothing to the provider who is being paid by equity shares. It feels entrepreneurial and collaborative, so what’s not to like?

The first issue that must be addressed is what value you attach to the shares. This value is calculated by multiplying the price of the shares by the number of shares – that’s the easy part. The hard part is determining what price the shares should be valued at and the good news is that there are definite rules that come into play here to assist you. 

The golden rule is that you must value the shares with reference to the latest market value. This can be, for example, based on the price that you last sold some shares, provided that it wasn’t too long ago! Ideally you need to have sold shares within three months of the invoice date. However if there were no transactions, then you will have to justify the valuation using profit forecasts, but you must be careful to ensure that any shares sold later on are valued with relevance to the share price you valued in this transaction. 

 Valuation can become complex if there are no recent transactions to refer to and this is where you may need to bring in your accountant. 

Read more about equity:

• Family office interest in private equity funds grows
• North East holds its own in number of private equity-backed businesses
• Private equity explained

Just be aware of the commercial risks that need to be taken into account.

The £10,000 you may have agreed to pay for the service may end up costing you £100,000 as the shares you sold cheaply to the supplier may have increased ten times in value by the time you sell the company. So if you had valued them better, you would have only sold 1,000 shares at £10 each instead of 10,000 shares at £1! 

You have now made your supplier a shareholder in your business, so he has the right to act like a shareholder and he can ask to see your accounts, which may make it difficult to agree a future discount with him if he sees you had earned large profits.

If you don’t ask the supplier to sign up to a shareholder agreement, you could find that the shares get sold on by the supplier without you knowing who they got sold to until it’s too late. Therefore the shares could fall into the wrong hands, such as competitors.
If the service performed by the supplier is poor, it can be more difficult to resolve if the supplier is also a shareholder as well as your key supplier.

Make sure that the agreement to issue equity includes the VAT as this still needs to be paid by the supplier for the service which they may not realise.

Don’t forget about including these shares in your books and registering them at Companies House as this is often overlooked.

In conclusion businesses entering into a sweat equity arrangement need to:

1. Properly value the equity they are agreeing to exchange and get proper advice;
2. Ensure the equity is properly recorded in the company’s books so everyone is aware that equity was issued; and
3. Ensure that the supplier’s service consistently meets expectations before agreeing to pay them through equity. 

Nyall Jacobs is a partner at chartered accountancy firm Carter Backer Winter.

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