What are creative ways to attract employees to your startup without having funding or giving away too

much equity?

Since your concern is compensating early employees without funding while carefully managing equity,
I’d recommend compensating with sweat equity in the form of a Royalty Agreement. I’ve posted an
answer on how to do that here: Wade Myers's answer to What are the different ways a startup business
can fund its operations without giving up equity?

What are the different ways a startup business can fund its operations without giving up equity?

In most cases, the issue of funding operations in the early days is the cost of attracting the talent
you need to build out your MVP and get launched. A creative way of funding employee
compensation expense is with sweat equity.

There are various forms of sweat equity (more on that here: Sweat Equity 101), but since you are
sensitive to doling out equity, I’d recommend using Royalty Agreements for compensation as
sweat equity.

Issuing royalties in exchange for sweat equity can serve to benefit both the Company and
Consultant (the person contributing effort in exchange for sweat equity) in several ways.
Royalties Defined: The Consultant receives compensation by receiving a royalty position in a
particular asset (intellectual property, a completed project or case, etc.) rather than ownership in
the company as a whole.

Why Royalties are Popular: A royalty agreement provides a unique benefit to a Company in
that it can be used to compensate for sweat equity based on all of the company’s net revenue or
for only the net revenue of specific products or services. For example, if a consultant is
contracted to develop a specific offering, the company may want to consider only compensating
the consultant with a royalty on the sales of the particular offering, rather than other offerings
that the consultant was not part of developing under a Statement of Work.

What sets royalties apart from any other form of sweat equity is that the Consultant is receiving
immediate payment whenever the offering is sold to a customer. Additionally, the Consultant
gets compensated along the way without having to wait for a liquidity event.

Benefits for Companies When Using Royalty Agreements:

 Compensates the Consultant only for their completed work. The company has the ability
to pay royalties based solely on the sales of a particular project that the Consultant
worked on, rather than all of the Company revenue generated from other products.
  Consultants are incentivized to work harder. Consultants have the incentive to work hard
to create the best possible product or service since their work has a more direct and more
immediate impact on their potential compensation, rather than a far-into-the-future
potential exit event.
 Potential tax deduction. Royalty payments are typically tax deductible.
 No obligations at the conclusion of the agreement. At the termination of the royalty
agreement, the issuing company has no equity dilution and no debt to pay off.

Downsides for Companies When Using Royalty Agreements:

 They must be paid regardless of the circumstances. The Royalties are paid on revenue
and therefore the Company is obligated to pay whether the Company is profitable or not.
 Mandatory cash expense. Royalties require a cash expense along the way as the
Company grows, rather than back-end equity-based proceeds at an exit as would be the
case if the Consultant was paid for their sweat equity in some form of equity. You will
want to set aside sufficient cash for the anticipated royalty expense and manage investor
expectations in your financial model (Startup Financial Model) on the earnings impact of
the royalty expense.
 The Consultant knows the company’s revenues. Since a royalty is based on revenue, the
Consultant will know the Company’s revenue, which may be a sensitive issue. However,
if you are following a best-practice process, the Consultant has performed the work under
a Proprietary Information Agreement (this is included in our Sweat Equity app), so you
would have the expectation of confidentiality.

Benefits for Consultants When Using Royalty Agreements:

 Excellent alignment. Consultants are rewarded based upon the success of the product they
helped produce.
 More predictable than equity. A royalty agreement will usually produce some income for
the Consultant since many startups will experience revenue, while most will fail to ever
have a successful exit (more on startup failures here).
 Possible loss decreases with each received payment. Royalties are paid as the Company
receives revenue. Therefore, with each additional payment, the Consultant’s possibility of
the loss of the value of their time investment decreases.

Downsides for Consultants When Using Royalty Agreements:

 Personal income tax rates. Royalty payments are taxed at personal rates, rather than the
potential for Capital Gains tax as may be the case if the Consultant was compensated
with an equity-based incentive.
 Capped Upside. Royalty agreements usually have a capped upside, such as 2x or 3x the
Consultant’s time for the risk premium, whereas an equity incentive is uncapped. In the
cases of a very successful startup, an equity incentive would offer an unlimited upside for
more overall potential.

The Bottom Line: When a Royalty-Based Sweat Equity Agreement Should be Considered:
 1. When the sweat equity contribution is smaller in scope and tied to the development of a
specific product or service
2. When the Company and the Consultant want to more closely correlate the variable upside
for the Consultant to the success of their contribution in the market
3. When the Consultant needs/wants payouts over time rather than waiting for a liquidity
event for an eventual payout
4. When the Consultant understands that the tradeoff is to pay higher personal income tax
rates on a more predictable royalty payment rather than pay lower capital gains tax rates
on the less certain gain in equity value

See Sweat Equity for more details or to use our super-simple, low-cost app to quickly negotiate
and document a sweat equity-based royalty agreement.

How much equity do you give a co-founder at different stages of a startup: 1. After creation of a
prototype, 2. Creation of initial MVP, 3. Getting an initial set of users, 4. Getting a large set of users, 5.
Getting the first paying customers, etc.?

First of all, I love the way you are thinking about it, because way too often Sweat Equity is just
granted in one big chunk as in the following scenario where irrational enthusiasm leads to over-
commitment and poor communication:

 Startup Founder: I’ve got a great idea!

 Sweat Equity Consultant: I can develop the entire app for you!
 Startup Founder: I’ll give you x% of the company!
 Both: Let’s just wing it!

The tendency is for each side to over-commit and over-promise with a vague vision, vague goals,
and a vague timeline. In addition, everything is poorly documented due to the time and expense
to do so properly.

The danger is that Sweat Equity arrangements often don't go well because the work is typically
not well defined, often not well delivered, and promises of equity are often not kept, resulting in
unmet expectations and a bad business divorce.

I’ve used sweat equity arrangements numerous times when hiring consultants for startups and
when advising startups in exchange for sweat equity (typically in the form of warrants), so I’ve
lived with the consequences of both granting and receiving sweat equity (and I’ve seen lots of
startup horror stories involving contentious ownership fights). I’m also a partner in a venture
capital firm that invests in tech startups and from my perspective, it’s critical to issue Sweat
Equity correctly to successfully set up the next stage of a startup launch and fly through the
venture capital due diligence process.

Nothing will kill a potential VC investment quicker than a sloppy or vague ownership structure
without the proper legal documentation and protections.
There are three key concepts to keep in mind regarding Sweat Equity:

 Forms of Sweat Equity - The type of Sweat Equity can take on many different forms,
from founder’s stock to a stock warrant to a revenue royalty, or even a SAFE (Simple
Agreement for Future Equity) or a Convertible Note, both of which convert into Series A
preferred shares in a qualifying venture capital round.
 Risk Premium - Sweat Equity compensation needs to involve sufficient upside value to
offset the risk of trading time for an uncertain future outcome, known as the “risk
premium”.
 Mix of Compensation - In many cases, a Consultant is contributing effort to a Company
will need some amount of cash in order to sustain their living expenses. Therefore, it’s
often important to keep Sweat Equity arrangements flexible with a mix of some cash and
some risk premium in the form of non-cash Sweat Equity compensation.

Here’s the process I recommend, which is going beyond just different stages, but is based on
statements of work with very specific deliverables:

(Lot’s more detail here on the ins and outs of Sweat Equity:
https://www.sweatequity.com/swea...)

Because of all the issues with Sweat Equity, I ended up collaborating with a number of attorneys
over the years to develop sweat equity agreement templates that incorporated all of the necessary
terms to protect both the startup founder that issues Sweat Equity, and the startup consultant or
advisor that works for sweat equity.

And, as a dyed-in-the-wool entrepreneur, I had an app developed to create iron-clad sweat equity
agreements quickly and easily and at a very low price for startups: https://www.sweatequity.com/
When someone is working for sweat equity what type of legal forms need to be filled out so that it can
be paid later?

My recommendations for a Sweat Equity deal done right would be as follows:

Background - Read all about what Sweat Equity is and the various types of Sweat Equity at
Sweat Equity 101

The Terms - Most Sweat Equity arrangements get off to a bad start without full clarity on
exactly what the deliverables are going to be by the person contributing sweat equity (the
“Consultant”), the value of that contribution by the Consultant, and how that value will be
compensated by the Company (there are many different forms of paying for sweat equity). Once
the Terms are clarified, then we can move on to the Documentation.

The Documentation - The proper documentation in terms of the legal forms should include the
following:

 Sweat Equity Agreement - The core consulting agreement between the Company and the
Consultant that spells out the overall arrangement and refers to each individual Statement
of Work
 Statement of Work - The agreement that clearly outlines the specific work to be done by
the Consultant in exchange for the Sweat Equity or a combination of Cash and Sweat
Equity. This should be very clear on the deliverables and the specific value of those
deliverables in very small chunks of work to avoid the vague “I’ll build the app in
exchange for owning 25% of the company”
 Proprietary Information and Inventions Agreement - The detailed confidentiality
agreement that also makes clear that the Consultant’s work is owned by the Company
 The proper form of agreement that covers the specific type of Sweat Equity, which may
be one of many forms:
o Amendment to the Organization Documents - If issuing additional founder’s
equity, then the Operating Agreement or Charter should be amended to cover the
issuance of additional equity and adding a shareholder or member
o Stock Warrant - If issuing equity under a warrant with an agreed upon strike price
o SAFE Agreement - If the sweat equity will be granted in a SAFE (Simple
Agreement for Future Equity) whereby the Consultant gets the equity as part of
the next investment round
o Convertible Note Agreement - If the sweat equity will be granted in a Convertible
Note whereby the Consultant holds a note that converts into equity as part of the
next investment round
o Royalty Agreement - If the sweat equity will be paid through a Royalty or
revenue share agreement where the Consultant gets paid via a revenue royalty
o Stock Purchase Agreement - If the sweat equity will be paid through a stock
purchase agreement and Bill of Sale (be careful of the notion of just “granting
equity” in exchange for sweat equity as it creates a taxable event)
I would generally recommend avoiding stock options or unit appreciation rights at the sweat
equity stage since the Consultant is usually an independent contractor and not an employee.
(That’s why I recommend a Warrant as one of the forms of payment instead of Options.)

Here’s an easy-to-use app to quickly put together an iron-clad Sweat Equity agreement at
SweatEquity.com