It’s difficult to find an exceptional Manager worthy of receiving shares in your company. How do you choose the right person? How do you structure a sweat equity plan which serves to motivate and commit? How many shares are required to serve your purposes? When do you offer the sweat equity plan? The biggest trap in offering sweat equity is that an employee will treat your promise of equity as a lottery ticket. Any employee does this when he or she likens the probability of a payout to that of winning the lottery. When this happens, he or she sticks the sweat equity in a drawer with the hope of winning, and continues acting like an Employee, not an Owner. For a founder, nothing is more disheartening than sensing that you may have wasted a share of your precious investment for no sweat.
Following the successful launch of your enterprise, choosing an equity partner may be a critical success factor determining whether you manage to grow your business to the next level. This decision can greatly affect your ability, ultimately, to optimize and monetize the value of your Company.
For a house cleaning startup, the risk of failure is initially so great that it almost never makes sense to take a “sweat only” equity partner on-board until your Company has achieved break even cash flow. Until you have demonstrated profitability, it’s difficult for anyone except a co-investor (someone matching your financial investment) to value a share in your company higher than a lottery ticket. So throughout the startup phase, your economics may force you to wear many hats. As your enterprise grows and becomes successful, you will reach the limits of your own ability to manage all aspects of your business effectively, perhaps by month eighteen, for example. Hopefully by the time you meet this threshold, your company is cash flow positive, and you have begun to pay yourself a modest wage. As you reach this stage, then you begin to search for the right Owner / Manager prospect to wear some of your hats. Some obvious roles include a Marketing Manager to perform in-home quotes, a Training & Quality Manager to maintain excellence and consistency, a Customer Service Manager to manage and process requests from customers and prospects, and an Operations Manager to manage dispatch, employees, and closing.
Our experience shows that you may have to test drive several managers before you find the perfect Manager qualified to assume a combination of these roles. Keep in mind, if you have a five-year plan, that finding the perfect manager can take time; each failed test drive can easily squander a six-month time segment. Considering the modest probability that any single Manager will pan out, whatever you do, do not include a sweat equity provision in any initial contract. There is nothing worse than hiving off a piece of your equity to a bad choice, losing that person, then working for an additional three years with a percent of your efforts enriching someone who is no longer on your team. In addition to the loss of wealth, the psychological affect can be difficult to bear for any shareholders who remain to manage the business. This really represents your worst case scenario.
Consider searching opportunistically for a Manager, rather than committing to making a hire at a specific time. When you find someone who seems to represent a likely prospect hire him or her on a test basis for just three months. During the test period, ask yourself daily whether your life is significantly better as a result of employing the Manager. Is the Manager as effective, or even more effective, than you in their assigned role? Is the Manager perfectly dependable, mature and trustworthy, to such an extent that he or she can manage the business during your vacations? Is the Manager presently carrying out his or her duties in a manner more closely resembling an Owner or an Employee? What is the likelihood that the Manager will remain with your Company for five years? If after the trial period the answers to ALL these questions are satisfactory, then you may have finally found someone worth at least considering for sweat equity.
Once you have cleared the important hurdle of identifying a prospective minority partner, the next step is to create a basis for bestowing value. This is accomplished by updating your business plan to show your current positive cash flows, and your forecasts for growth in profits and proceeds from the eventual sale of the company within a reasonable time frame, say, three to four years. Additionally, you will require a shareholders agreement which includes provisions to protect a minority shareholder, such as super majority votes to authorize increases in capital and changes to officers’ employment contracts.
If you have decided to offer sweat equity to a manager, you should consult an attorney to review and possibly prepare sweat equity provisions in an employee’s contract, as well as a minority shareholders agreement. Sweat equity cannot be effective if its foundation is nebulous, so it’s foolish to make promises about equity which are not contractually binding on both parties. The structure of your offer will impact how effective your shares are in motivating your Manager to act like an Owner, and committing him or her throughout the growth period and even beyond.
What percent will you offer? Your offer should be structured to result in a win – win scenario. This can be achieved if your offer serves to motivate the Manager to act like an Owner rather than an Employee, while still enhancing your organization’s overall value sufficiently to compensate for the projected dilution in your own equity stake. If you are a growing, prospering enterprise, and you expect to eventually generate several hundred thousand dollars per year in free cash flow, then you might ultimately expect to realize over $1 million, through the sale of your Company. Under such a scenario an offer of 10% sweat equity might prove attractive to a Manager, while still offering the prospect for a net gain in value to yourself.
Once you have an effective legal structure in place and feel confident about the candidate, then explain it to the Manager informally with the purpose of estimating what effect a sweat equity offer might have on the Manager’s behavior. Does the Manager accept that the sweat equity will not vest before a couple years or so, and that he or she will receive zero if the parties, for whatever reason were to part ways prior to the vesting date? Does the Manager understand that you intend to retain him or her through the vesting date only in the event he or she is able to make a sufficiently positive impact on the Company’s results, thereby making you richer? Is the Manager jumping up and down about the possibility of being offered sweat equity? Structure the plan reasonably and explain it well. Then, if the Manager is not popping like popcorn about the prospect, don’t waste your equity.
There are a few important matters to consider in drafting a sweat equity plan. Of primary importance is the treatment of your financial investment in the Company. You might consider classifying all investments by you as a loan which must be repaid prior to the distribution of any dividends. Another important matter relates to relative wages. This should be agreed in advance and your employment contract with the company approved in shareholder meetings preceding the offer of sweat equity. Our experience shows that there can be advantages in maintaining modest wages to officers and distributing profits to shareholders, especially in years preceding a prospective transaction.
This brings us to a final point about the issue of sweat equity. One of the primary reasons to offer it is to make your Company’s success less dependent on you. Unless you are successful in breaking this dependency, then you will find it difficult to sell your Company. With this in mind, you should consider including in the Manager’s employment contract a provision which obligates the Manager to continue at his or her current salary level, in the employment of a Buyer for a full six months following the transaction date, at the Buyer’s option, of course. Doing so can greatly enhance the value of your Company, and facilitate its sale and the handover process.
For more information about How to Prepare your Company for Sale, and How to Value Your House Cleaning Company, consider subscribing to the HCA How To Booklets