5 min read
Read time
Published on
October 11, 2022
by
David Stockton
Sweat Equity Best Practices

SWEAT User Guide

The SWEAT Note is designed to facilitate sweat equity investments between startups and their core service providers in a way that is mutually beneficial to both parties, wherein the service provider provides critical growth services at some discounted cash rate in exchange for a convertible note that will convert into equity at a later date. Startups receive the services needed to drive growth in their business in a manner that is cost effective and preserves a startup’s most important assets: time and runway. Vendors get to share in the value they help create in their startup clients in a way that is not attainable through normal billing. This increased alignment of both parties' interests will not only drive additional value, but will reduce the failure rate commonly associated with early-stage businesses. In this document we will outline the structure of this note in a way that we hope is more digestible than legalese, and shine a light on the potential benefits for users of the SWEAT Note.

The SWEAT Note is designed to accompany a service contract, or VendorAgreement, which specifies the total engagement amount. The SWEAT Note inherits this amount, and the terms of the note dictate what portion will be paid in cash versus in future equity and how the note will convert into equity.

There are three core negotiating points for service providers and startups designed to compensate service providers for their assumed risk associated with taking on equity investments in lieu of cash. The first is the SWEAT Rate and SWEAT Amount. Respectively, the SWEAT Rate is the proportion of the engagement paid in future equity, and the SWEAT Amount is that figure as a dollar amount.

The following two terms determine how the SWEAT Amount earned by conversion will be treated. The Discount Rate takes the startup valuation agreed to by the lead investor in fundraising and reduces it, with the core concept being a service provider’s work investment will drive an increased valuation for the startup at its next fundraising round This is favorable to service providers as it means their investment will convert into more equity. This is important because without a discount rate incentives would not be aligned to drive a high valuation. For example, assuming $100k of services, a 20% discount, and a $1M valuation, the conversion without a discount rate would be worth 10% of the startup’s equity, instead of 12.5% with the discount rate. The last main negotiating point, the Interest Rate, focuses on the vendor instead of the startup, and aims to compensate the vendor on the opportunity cost associated with accepting equity. In simplest terms it is the annualized interest rate that will be applied to work done by the service providerprior to conversion into equity. For service providers who work with startups regularly and are well suited to the work-for-equity model this should be zero or relatively low. This is instead designed to help service providers who would be struggling with bandwidth and would be giving up a cash paying client to free up room to work for equity. In these cases we suggest that interest rate should mirror the performance of the broader market, such as the S & P 500 benchmark index.

Almost all negotiations will take place on the above parameters, with enough flexibility provided to allow for an equitable arrangement between almost any class of vendor and startup. It’s possible to re-work these terms for extenuating circumstances, but we recommend against this. . The main portion of the SWEAT governs the events under which the note converts, and will be readily familiar to users of the SAFE. The Equity Financing subsection describes the event that will trigger the conversion of debt into startup equity, subject to the SWEAT terms. This is designed to be the subsequent fundraising round at an increased valuation, thanks in part to the hard work performed by the service provider. Liquidity Event covers a sale of the startup prior to conversion of the SWEAT note into equity, in which the service provider will receive the greater of two options. The first is called the “cash-out” amount, which is the amount of convertible debt accrued at the time of liquidation, including any accrued interest. The second treats the liquidation as a conversion event and calculates the amount owed to the service provider based on its pro-rata ownership of the startup. Reorganizations of the business for tax-purposes do not count as liquidation events. Dissolution event covers the distribution owed to service providers in the event the company goes out of business. This is equal to the amount of work performed as of dissolution. The dissolution cash out is subject to Liquidation Priority, which determines who will be paid out in what order. Service providers using the SWEAT Note will be paid out after non-subordinated debt (which Lynx.Ventures covers most debt unless specifically noted as subordinated debt) in the same class as preferred stock holders, who are paid out prior to common stockholders. The last event covered is a Termination of the sweat note, which can only occur if there has been breach of compliance from either party, or upon the conversion of debt into equity in accordance with the terms outlined in the SWEAT.

The next section of the sweat focuses on providing clarity to the terms used throughout the note. These definitions are boilerplate terms used in convertible debt notes, and are primarily used to ensure both parties have the same understanding of what is covered by the note in the case of a legal dispute down the road. We won’t cover all the definitions in this document as most are largely self explanatory, but we will draw your attention to a few of the less intuitive terms mentioned. Change of Control, as it relates to liquidation events, occurs when the beneficial owners of the company have changed. Changing members of a board of directors would not trigger this, but as a general rule of thumb if the ultimate decision maker has changed a change of control has occurred. SWEAT Preferred Stock is in reference to the equity class that the SWEAT note will convert into, giving the service provider the same rights and benefits as other preferred shareholders enjoy.

The next two sections outline the good faith representations made by both parties about their companies and the engagement agreed to. On one side the company represents that it is legally incorporated and in good standing with the laws and regulations in the state it’s incorporated in, the company has the power to execute all aspects of this agreement, and the agreement does not violate any laws or regulations of or for the company, including in its bylaws. On the service provider side, the vendor is also in compliance with all applicable laws and regulations, the entity is aware that acceptance of equity will occur at conversion, and will follow all regulations surrounding the ownership of equity, including compliance and reporting requirements.

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