When is the best time to do a sweat deal?

A question we often here at Lynx about sweat equity is, when does it make the most sense to do a sweat deal? Founders want to know how to use sweat as a fundraising and recruiting tool along the lifecycle of their business, and service providers want to know when it makes business sense to defer cash revenue for equity. There’s no one answer, but instead we try to equip Lynx members with tools to make smart decisions.

When Sweat Makes Sense in the Venture Lifecycle

Mostly we find that sweat deals make sense as part of a mixed cash and sweat fundraising round, typically at the seed stage of a company. These founders are raising sizable amounts of capital and hiring for all functional areas—in this case sweat is a strategic tool to either allow for a leaner cash raise or extend the runway afforded by that raise. When sweat accompanies cash, it allows founder to be able to pay for expenses that cannot be paid in equity (often, payroll!) but enjoy the benefits of sweat equity. Namely, their critical providers will have the same buy-in as senior in-house talent, in a win-win where the ROI of that service is greater than its cash value.

Sweat fundraising also makes sense as first money—attracting a partner to work on a new project for equity in that project, can make much sense when it’s a niche and well scoped investment, again where the service provider offers unique value. This sweat investment can de-risk the overall venture and next round, and bridge the organization to be in a stronger position to raise cash. The benefits to the provider are a high-degree of influence over the future of the company, and a premium as an early angel.

Lastly, sweat offers advantages to bridge between later stage rounds. Raising sweat equity from service providers can extend runway between rounds (perhaps in uncertain macro conditions!).

When Sweat Maximizes Expected Value

Service providers have unique insight into what the return of the investment of their particular service will be (that almost no cash angel investors have!). This allows service providers to time the injection of their services with when it will have the greatest impact on the target organization. Read about this at length in our article on diligence.

When Sweat Maximizes Earnings Potential

Service providers must also consider the impact these investments have on their firm’s overall earnings potential, in the same way that any business operator optimizes business resources. For most service businesses, it makes most sense to look to sweat up to their profit margins. Under this model you essentially are able to divert your profits to venture exposure, and increase your firm’s overall earnings potential dramatically.

Depending on the size and nature of the business, this might mean using a sweat rate equal to your margin for every deal, or only doing an amount of sweat deals to complement an amount of cash deals. This is best executed when paired with a broader venture thesis—perhaps for example you are betting on startups that will have unique benefits for your vertical or other clients.

Sweat deals can also be tools to motivate and reward employees, or make use of what would otherwise be “bench resources” or idle time. We find most organizations can optimize their potential earnings by targeting an overall mix of equity and cash compensation based on their margins, risk tolerance, and venture thesis.

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