Is Sweat Equity Worth Anything? (Part 1 of 3)

I’m not an attorney, but I’ll use their two favorite words: it depends.

Most people are familiar with the term ‘sweat equity,’ but let’s start there if you’re not. From Investopedia:

Sweat equity originally referred to the value-enhancing improvements generated from the sweat of one’s brow. So when people say they use sweat equity, they mean their physical labor, mental capacity, and time to boost the value of a specific project or venture. In cash-strapped startups, owners and employees typically accept salaries that are below their market values in return for a stake in the company, which they hope to profit from when the business is eventually sold.

This isn’t the end-all-be-all definition, but there are some interesting concepts I think directly map back to the original question: is sweat equity worth anything? Let’s address them below.

How is sweat equity tracked?

I’ve talked to dozens upon dozens of web3 teams in the last couple of months leading up to the launch of Sporos, and at least 75% are using — or are interested in using — some form of sweat equity. However, all of them are using spreadsheets, notion, Coordinape, peanuts (jk), or some other off-chain method to keep track of who’s earned what.

I’ve seen a mix of solutions for who actually makes the decision on how sweat equity is distributed. In some cases, it’s the founder(s) who make the distribution arbitrarily (aka benevolent dictator for now [Raymond 1998]). In other cases, it’s done through social consensus [CommunityRule] and an attribution tool such as Coordinape. Sometimes it’s somewhere in between.

If you’re in a small team with people you know and trust, then maybe these solutions work, but none of those options are immutable, un-ruggable, and indisputable. Even still, you also need trust in the equation because your off-chain, gentleman’s-handshake sweat equity needs to become legally enforceable and actually tie to ownership in the company. A lot can go sideways in that process, especially if the team is disbursed/non-profit, have widely divergent expectations (side project of love → career path), or external financing/dilution is anticipated.

In these cases, let me answer the question by asking a question: How much is your sweat equity worth if you have no equity at all?

What does sweat equity represent?

Most of the time with startups it’s a handshake. Founders can make promises to early team members/advisors without having agreements in place promising future equity based on contribution provided. On one end of the spectrum it’s an ambiguous “just trust me, we’ll take care of you,” and on the other end there’s an actual formula recorded in excel or something similar. Rarely do these promises instantly map to an actual binding agreement which marries with the legal entity itself. So, sweat equity represents air until it doesn’t — but the contributor isn’t the one controlling that call.

At the other end with collectives, this is one reason professional investment firms pass on a startup when they see the messy cap table and potential co-founder disputes. And without legal wrappers in place, the starting assumption is a business partnership with joint and several liability [Reyes 2019], including unpaid taxes.

If you’re fortunate enough to have sweat equity agreed to in writing, odds are you’re receiving warrants or compensatory options with a vesting schedule. This means that even though you have a future claim to financial rights in the business, you need to wait until they vest, and you have no governance power in the company until you exercise your options. As a result, you’re exposed to other people making decisions that could harm your position (e.g. founders entering into deals with VCs causing dilution, liquidation preference rights, forced down rounds, etc.), and you don’t have a seat at the table to stop it.

In web3, it gets even more convoluted. Many people are working for sweat equity but what does that really mean?

• Is it equity in the company itself? This assumes there is a company or separate legal entity, which is not true of most DAOs.
• Is it an existing governance token with no economic claims? Side note: DAO ‘governance’ is a whole separate can of worms for a later date.
• Is it allocation of a future airdrop? What exactly does the airdropped token represent? What percentage of the total will you receive? Who makes those decisions?

It’s more apropos to say ‘sweat token’ in web3 because rarely does it actually mean ‘shareholder equity’ in a valid legal entity.

In these cases, let me answer the question by asking: how much is your sweat equity worth if you don’t actually receive what you were promised and/or don’t have equity at all?

Is your company ultimately successful?

This is the obvious one, so I’ll keep it brief. You’re placing a bet on yourself, the team, and the company’s business prospects when you earn sweat equity. If the company has a liquidity event in the future, the hope is for the payoff to be financially more meaningful than if you accepted cash for your contribution, hence the risk-adjusted compensation. If the company is unsuccessful, well — that’s the world of startups [Grant 2019]. Smart contracts augmenting executing wet-ink agreements are enforceable to the extent that:

1. Contributions are measured using a common yard-stick (whether expenses or time bank).
2. Sunk R&D in intangibles can be aggregated and used to value enterprise on a cost-basis.
3. Tokens within valid securities framework can be exchanged/exited if legally well-formed.

The combination of transparency, valuation floor, and price discovery goes a long way to addressing participation in high risk early ventures where the market for equity stakes is opaque, thin (external investors not sure about sunk costs), and illiquid [SPICE 2017]. When the startup fails, the token is worthless and everyone chalks up a lesson in the school of hard-knocks. A successful outcome may actually surface prior conflicts exacerbated by poor/non-existent documentation [Carlson 2010].

How does Sporos solve these issues?

We’re quickly approaching the launch of Sporos. Sporos will enable teams to tokenize work in a legally enforceable form. These sweat equity tokens contain both financial and governance rights in the business and are legally connected to the company’s LLC. All of this is made available by instantly creating an LLC on-chain by leveraging the KaliDAO framework and leveraging the on-chain governance, project management, treasury management, and proposal tools built by Sporos.

Join our waitlist if you’re interested in using sweat equity for your project. We’d be happy to chat with you and help you even if you don’t use our product.

Come join us in our discord. Ask questions, get involved, or simply follow us on twitter to stay updated.

Disclaimer: This framework should not be construed as legal advice for any particular facts or circumstances and is not meant to replace competent counsel. None of the opinions or positions provided hereby are intended to be treated as legal advice or to create an attorney-client relationship. This analysis might not reflect all current updates to applicable laws or interpretive guidance and the authors disclaim any obligation to update this post. It is strongly advised for you to contact a reputable attorney in your jurisdiction for any questions or concerns.