Sweat Equity and ESOs (Employee Stock Options)
Sweat Equity is fundamentally the equity provided against the “sweat” (in contrast to money) while ESOs are stock options giving the employees the “option/choice” to buy the company’s equity at a predetermined price. ESOs are actually a sub set of sweat equity as exercise of ESOs results in employees getting equity at a discounted price.
Sweat Equity and ESOs are used by the start-ups and early stage companies to acquire talent when they cannot offer them their market price due to cash constraint. Sweat Equity and ESOs are also used to retain talent as these come with certain constraints like lock-in, vesting and non-transferability that make sure that sweat equity owners can benefit from it if and only if they have been with the company for a definite time. Sweat Equity is also used to motivate talent to perform better as company’s equity value increases with its performance, which in turns benefit the employees holding the company’s equity.
The following terms are often used in conjunction with sweat equity and ESOs-
Lock-in: Lock-in period is the time before which the sweat equity or the ESOs owners cannot monetize their equity. This time is generally three to five years for a start-up company.
Vesting: Vesting is the mechanism specific to ESOs that describes the time and number of ESOs the employee can convert into equity. Generally, start-ups allow 25% of ESOs to be converted into equity at the end of each year.
Non-transferability: As the name implies, non-transferability clause does not allow the transfer of sweat equity or ESOs from the original holders to anyone else. This means that either the ESOs can either be converted to equity or be expired after the vesting period.
Employee Stock Option Plans (ESOPs): ESOP is a plan through which company allocates ESOs to its employees based on their performance.
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Hi Neeraj,
I need to know the important clauses to look out for while joining an early stage startup on sweat-equity.
The vesting period, what happens if a successful exit happens before lock-in period expires.
Shouldnt sweat-equity be paid every month in lieu of the salary forgone every month.
thnx
munish
Munish
June 24, 2010 at 5:30 PM
The important clauses to look for are- Number of Shares (%age of total shareholding), Vesting Rules (%age of options to be converted to shares every year, conversion price (if any)) and Additional stock options every year.
Generally, options get converted automatically into shares if exit happens before the lock in. However, this may be overridden by some clause in the exit agreement so it is advisable to discuss this issue with the management of your company.
As far as I know, in case of early stage companies, sweat equity and stock options are paid at the time of joining however, it entirely depends on your agreement with the company. There is no definite rule for it. The idea of monthly sweat equity somehow goes against the basic concept of sweat equity/ESOPs which is to retain a capable professional for long term and to share company’s success with him/her.
Neeraj Jain
June 25, 2010 at 8:52 AM