Our Thoughts on Sweat Equity

Why Options Suck

Unfortuntely, the traditional approach requires negotiating an arbitrary percentage of the company, tying it to a stock option grant with a strike price based on some valuation, adding a four-year vesting schedule... and all of that is nonsense.

It's nonsense because nobody knows what an early-stage company is worth. Not the founders, not the employees, not even VCs—that's why most early stage investors use SAFEs instead of pricing rounds. So, there's no way to fairly determine the "correct" percentage based on a valuation that doesn't exist.

Options also lock employees into a long-term, consistent commitment. Four-year vesting with a one-year cliff? That assumes steady contribution for years. But life happens. What if someone needs to dial back for a few months? Ramp up? Leave early? With options, any deviation is penalized. It's inflexible by design.

The Fair Outcome

Fortunately, there's a better way. Both parties can agree on a market rate—an annual salary that reflects what someone else would pay for those services. There's a market for this. It's a knowable number.

And at some point, someone will value the company. That's literally a VC's job. When that happens, there's a fair formula:

The employee works however many hours they want. Those hours get tallied, multiplied by the agreed market rate to get a dollar value, then divided by the future valuation to determine ownership percentage.

The First Constraints

In an ideal world, executing this framework would be simple: figure out how many shares need to be issued, then issue those shares to the employee in lieu of cash, done.

But two things get in the way:

Minimum wage laws: Employment law requires paying (in cash) at least minimum wage for hours worked. Pure equity-for-labor arrangements aren't legal.

Taxes: If an employer paid someone entirely in equity, both parties would owe taxes on income never received as cash.

The workaround: Pay minimum wage (satisfying employment law), pay minimal taxes on that cash (satisfying the IRS), and then enable the employee to invest their net wages at a multiplier calculated to deliver equivalent ownership to what they'd have received at market rate.

The Final Constraint

Here's the thing: the workaround above shifted this from "equity in lieu of cash compensation" to a formal investment transaction. That means securities law now applies.

That's a problem because companies cannot make investment offerings to the general public. But, Regulation D Rule 506(b) does allow companies to accept investments from non-accredited but "sophisticated" investors—people who have formed a substantive relationship with the company and have access to the kind of information that would typically be available in a registration statement.

People like employees of startups. But not on day one. Not before they become an employee. You have to wait for a couple weeks, i.e. on or arround the 2nd paycheck.

The Bottom Line

It's possible to approach sweat equity fairly without stock options. The key is that the startup and the employee can't negotiate the terms of the "investment" up front. Instead, the parties have to agree to minimum wage and make no additional commitments or promises. Then, after a couple weeks, they can strike a deal. Stupid. But effective. Feel free to write your legislative representatives and thank them for making this so hard.

Calculating an Equivalent Discount

In a hypothetical scenario, here's how one could calculate a valuation discount that produces equivalent ownership between two different investment amounts (aka: wages reinvested):

Note: This is an illustrative example only—no investment offering is being made.

Going Deeper

Adjust these inputs to explore how the math works in different hypothetical scenarios:

This calculator is for illustrative purposes only and does not represent any actual offering.