Sweat equity is a great thing for many start-ups – but in creating it, you also create tax and shareholding issues! So what do you need to think about and how do you do it properly?
What is sweat equity?
Most commonly, the term “Sweat Equity” refers to unpaid labour, such as the physical labour, mental effort, and time that a person or company invests in a business venture or project. However, this term is used to mean something different when it comes to start-ups.
In the context of start-ups, sweat equity is where a consultant or service provider carries out work for the start-up and is paid in shares rather than money. The payment here is that those shares will (hopefully!) turn into a long-term reward as the value of the business increases and is eventually sold.
Why build sweat equity?
If you don´t know whether to build sweat equity in your start-up, weigh up the pros and cons!
Pros – an impoverished start-up can get huge benefits from sweat equity:
If you don´t know whether to build sweat equity in your start-up, weigh up the pros and cons!
- It can be considered as a useful form of start-up finance.
- The start-up can spend using equity rather than cash and thus be able to afford services that it couldn’t otherwise pay for.
- Companies can raise funds without raising debt levels.
- There are several tax-advantaged schemes to take advantage of.
Cons – paying staff by issuing sweat equity has its own raft of issues:
- The final value of your equity might be worth less than the work you put in.
- It is considered to be a form of income (since it´s given in exchange for a service and the service provider invoices for this service) – so the taxman wants to tax the value of that service.
- This can lead to cash flow issues for the service provider (if all they have are shares and no cash to pay tax on the profit and VAT on that service). Therefore, it might be better to pay equity partly in cash and partly in shares so that the service provider can cover their tax bills.
- You need to put a Shareholder’s Agreement in place to regulate the minority shareholder and avoid or minimise potential future problems. (This is the case for any business with more than one set of shareholders).
- You might need to go further and have a sweat equity agreement too, outlining what each side will do (i.e. what sweat the individual will contribute and what equity the start-up will pay).
- Issues can arise if the service provider doesn´t invoice, but the start-up still issues them with shares! The market value of those shares needs to be calculated at the time they are given – this is because the service provider needs to recognise the same market value in their tax return.
Background:
A start-up agrees to render its services to a start-up consultant in exchange for shares. The deal states they would receive 10% of the issued share capital, with 5% of the shares given now in exchange for £5k of the consultant’s time and another 5% when the business is ready for investment funding. The first £5k is invoiced (including VAT if applicable), and that bill is paid by issuing shares valued at £5k (5% of £100k since that´s the business´s current market value).
The issue:
Fast-forward 12-18 months later, when the start-up is pitching for a £500k investment, the business may now be valued at £5m. The second half of the sweat equity deal is due – however, in that time, the business has gone from £100k to £5m in value, which means that the 5% equity has gone from £5k to £250k.
For the start-up, it is just some shares, so there are no issues. However, for the service provider, they now have to recognise the current market value of the shares in their tax return, which means paying VAT, income tax and NIC on £250k with no cash to pay those tax bills!
The solution?
Start-ups need to consider alternative options to compensate their consultants. For example, paying part of the shares in cash, offering deferred payment, sharing equity over time, or offering additional benefits to offset the tax burden (i.e. stock options etc).
To navigate the tax implications of issuing shares for services, start-ups can also consult a tax expert. They can advise and guide you on the process, as well as manage your tax bill.
The bottom line
Want to build sweat equity in your start-up? While it is a great thing, it does come with its challenges, so it needs to be a well-thought-out decision.
If you run a start-up and you need advice, get in touch with us today. We can help you get your start-up running smoothly.
