Understanding Sweet Equity
Sweet Equity – often known as ‘sweat equity’ – is a financial instrument that acts as a non-monetary equity for the time and effort employees put into a company, usually at its start-up stage. You can use the term ‘sweat equity’ to consider how it represents the work the employee puts into the company that is valued above the (usually lower) salary they receive.
The ‘sweat equity’, meaning the labour, mental capacity, and time, an employee puts into boosting the value of a project or company is returned to them in ‘sweet equity’. This sweet equity usually takes the form of preference shares. We typically see sweet equity used to attract talent in start-ups as the employees are usually paid a below-market average salary, receiving a stake in the company in return.
Private equity investors utilise sweet equity as an incentive for a company’s management team to deliver a mutually beneficial positive return. Sweet equity is also referred to as “equity compensation” and “stock for services”.
What is Sweet Equity?
Sweet equity is a financial instrument for private investors who want to raise capital without incurring debt. This investment agreement provides investors with an ownership share in the company in exchange for its funding. Alternatively, sweet equity can also be used to attract top talent who receive an equity share of the company in recognition of the fact the start-up or company is unable to currently afford a salary that reflects their market value.
Start-ups and investors typically view sweet equity as a safer option than debt financing as it does not come with the same financial burden as loan repayments. Providing an equity stake as financial compensation can attract both private equity investors and key employees for start-ups and expanding businesses.
When sweet equity is provided to employees, it’s typically referred to as “sweat equity” in recognition of the work an employee puts in above their salary level. Sweat equity can also be utilised by more established companies in recognition of employees who go above and beyond. Utilising sweet equity in this way can promote greater employee retention and internal career progression.
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Sweet equity is becoming increasingly common amongst start-ups and businesses seeking to avoid debt financing in the current economic situation. Start-ups operating with limited liquidity typically have to pay their employees a salary that they would receive with a more established company. Sweat equity allows start-ups to still attract top talent by incentivising them with profits they could earn through the eventual sale of the start-up.
Sweet equity shares are typically issued to senior employees during a leveraged buyout with a private equity firm or partner. These shares are issued at a lower price than other shares, giving employees and private equity partners a higher profit margin. Private equity firms that utilise sweet equity will receive a higher share of the equity sale as part of their exit.
Sweet Equity in Practice
Sweet equity is non-monetary equity that the company’s owners or employees contribute to the business. These financial instruments work to increase the value of the management team’s equity in the company, usually over that of other shareholders. While shares are the usual financial instrument that is utilised through sweet equity, employees may also get performance rights, options, and restricted stock units as part of their package.
We typically see sweet equity in practice with start-up companies. While sweet equity could in theory be offered to any employee of a start-up, it is typically focused on the management team. These CFOs, FDs, and executives are usually attracted to the company by its future buy-out potential. Such executives will form the company’s management and leadership team, sacrificing a higher salary in exchange for preference shares in the company.
The sweet equity shares are issued to employees with an exercise price that is below that of the current market price. It acts as an incentive for the company’s management to focus on value creation and boost its profitability. Management teams that are successful in this will receive a greater share of the company’s equity profits in the future when it is sold.
Employees and management will be incentivised to hit the private equity firm’s performance criteria in order to access the sweet equity money. The internal rate of return on investment will act as a benchmark for the management to aim for. Most investors will set the IRR at 30%. Management will want to clarify with private equity investors early on how partial sales, dividends, equity issues, refinancing, and fees may affect the IRR in the future.
Determining the Value of Sweet Equity
There are various ways that a company can determine the value of sweet equity for management employees and private equity firms. Mike Moyer’s 2012 book ‘Slicing Pie: Funding Your Company Without Funds’ promotes the ‘Slicing Pie’ model that determines the value of sweat equity through the relative value of each employee’s unpaid fair market compensation.
Start-ups and new businesses will typically determine their value based on equity capital sale. If a private equity investor firm invests $1 million for a 20% equity stake, the company itself should have a $5 million valuation. Most companies that utilise sweet equity are working with private equity firms. If the company does not have equity funding, it can work out its valuation by using the company’s brands or existing assets. Alternatively, it can estimate the total value of its equity by using the value of similar companies.
While it’s relatively easier to put a fixed price on sweet equity, calculating an employee’s sweat equity is more subjective. Employees and management will usually negotiate to determine what an individual’s sweat equity is. The sweat equity won’t be firmly calculated until an IPO, sale, or valuation puts a firm value on the company’s equity. When the company is sold or receives a market value, employees receive their sweat equity in a cash or stock payment.
Sweet Equity vs. Sweat Equity
It’s not uncommon for ‘sweet equity’ and ‘sweat equity’ to be used interchangeably. Both phrases refer to the non-monetary equity utilised by start-ups and smaller companies that offer equity shares to avoid debt financing. Private equity firms may receive ‘sweet equity’ in a company when they invest in it.
Alternatively, employees can receive these same preferable shares as part of their package to compensate for a lower salary than their market value. These shares become known as ‘sweat equity’ in recognition of the work that the employee and management team put into enhancing the company’s valuation. Start-ups with a small amount of funding will utilise sweat equity to attract talent, particularly in the technology industry and emerging fields.
Sweet Equity and Private Equity
Sweet equity is typically utilised in companies that are being funded by private equity. There are two things that a company’s management has to consider when agreeing on a private equity deal; the price the investor is paying (the enterprise value) and the sweet equity that has been built into the investor’s financial strategy.
The sweet equity within this strategy is the shares set aside for company management. The ‘sweet’ terminology reflects the fact that this equity is very cheap and allocated early into the private equity agreement. Most shares have zero value because of the debt put against these early shares at the beginning of the private equity funding venture.
Private equity firms are increasingly using sweet equity to align the management’s interests with their own, united under the internal rate of return on investment that the PE firm is seeking prior to an exit strategy. The view is that management will be more incentivised towards value creation if they have a stake in the company itself.
The company’s C-suite and management teams will typically be allocated sweet equity. However, it can be extended to virtually any level of a business. If all employees receive sweet equity, it’s known as an ‘employee share plan’. Most companies will limit the sweet equity programme to its senior leadership and one level below it. Some private equity firms prefer to concentrate the sweet equity on employees who make the most meaningful contribution to the companies. Others choose to widen the pool to incentivise each employee.
Why Companies Use Sweet Equity
Companies utilise sweet equity to attract and retain talent. Sweet equity can be viewed as a type of performance share with the private equity firm determining its target. This equity can only be realised when the company is sold or goes for an initial public offer (IPO).
Sweet equity can speed up a company’s growth by providing access to additional resources it would not be able to use if it paid employees a higher salary. This additional funding can be used to purchase inventory, invest in further research and development, or higher more employees. Start-ups view sweet equity as a way of reducing financial risk while maintaining control over the company’s decision making.
Why Sweet Equity Matters
Sweet equity is a lifeline for start-ups and companies that are short on cash. Founders are naturally at a disadvantage because of limited funds, making it harder to grow their company and attract the right talent.
Sweet equity provides a way for companies to attract talent before it becomes profitable. These companies view sweet equity to be as valuable as cash equity. Private equity firms are searching for small companies that have the potential to drastically expand. These companies usually have employees who have taken a pay cut or are receiving a smaller salary than they could receive elsewhere in exchange for stock options. Management employees who receive sweet equity have the same goals as private equity investors.
Companies view sweet equity as a way of fundraising without increasing its debt levels. Many start-ups fall into the trap of developing too much debt, inevitably crippling its finances, and limiting its potential. Sweet money enables the founder to sell a portion of the company to investors
The Risks of Sweet Equity
There are two sides to the sweet equity strategy. While it’s easy to see it as a win-win for start-ups and expanding companies, there are risks involved with sweet equity – for both investors and the company founder. Sweet equity can lead to a dilution of share value if there are multiple subsequent rounds of shares issued.
There can also be complicated legal implications for a company that is using sweet equity. The company may need to take on legal advice and carefully navigate the legal implications before entering a sweet equity agreement with a PE firm or its employees. Investors who use sweet equity will want to diversify their portfolios as much as possible to reduce their vulnerability.
Recruit a Private Equity FD or CFO Today
FD Capital is the UK’s leading financial recruitment agency with a portfolio of specialist CFOs and FDs with extensive experience working in private equity. Many of our candidates have experience working in sweet equity situations.
Working with a specialist recruitment agency like FD Capital is the most effective way to identify a financial executive with the private equity skills and experience to maximise your company’s potential.
We provide a 360-degree approach to tailor the recruitment process to suit your goals with both traditional recruitment services and CFO headhunting services. Our hands-on approach to recruitment starts by identifying the specific needs of your company and whether you need an industry specialist or a CFO with the experience to fill a skills gap.
Take your company to the next level by recruiting a private equity CFO or FD with experience working with companies utilising sweet equity. Contact our specialist team today at recruitment@fdcapital.co.uk or call 020 3287 9501 for a no-obligation consultation.
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