You can jump straight to the calculator, or read on to understand the mechanism behind it.
When you are just starting out in your exciting startup journey, you either have other co-founders who work with you to bring out the product or pay contractors to help you build it (or both). In return, co-founders get equity (sometimes cash salary too) while contractors get cash.
There is another way, which blurs the line between the two above. You could make a part-equity-part-cash offer to people who would help you build the product. Part-cash would give contractors down-side protection, while part-equity would offer (in theory, unlimited) up-side for some of them willing to gain exposure to your venture’s future growth. For founders like yourself, it preserves cash when cash is tight, and shifts some risk to contractors. A variant is a full-equity approach that some venture builders adopt to help early-stage startups complete MVPs and be fundraising ready.
Now switching sides: say you have worked in a multinational tech company since you graduate as a developer, and you feel that time is right to take the plunge to join a startup. You prefer a greenfield project and you happen to bump into a few founders who all have their own concepts ready to go. You want to work with them to try it for yourself, but it may be premature to settle with one of them to join as a technical cofounder. A part-equity-part-cash offer seems attractive at this point because you will get paid for your work, and you will be engaged further along the startup’s journey, not to mention the possibility of landing a job working with the same people post-funding.
This contract is what I call Sweat Equity Convertible Contract. Despite the seemingly win-win scenario it would create, setting up such a contract can be nuanced, not to mention that without a shared understanding of how it works, it can be difficult to even start the negotiation.
This post aims to formularise the contract, by borrowing the idea of convertible note as an instrument commonly used in early-stage venture investing, plus a little twist on employee option grants. The goal is to align both founders and contractors on a few key points when setting up SECC to smooth out and speed up the negotiation. After all, their interests should be aligned given that they are about to enter such a contract that obliges them to shoulder some risk together.
Further along the journey, you may add advisors and non-executive directors who are also likely to be compensated on a mixture of cash and equity basis. With fractional employment gaining popularity, more professionals are looking to engage in this type of compensation too. When negotiating and deciding the compensation structure for those roles, the same approach applies. I use contractors thereafter as the term to cover all recipients of such a compensation structure.
A word of warning: only use SECC when both parties are in for the long run
Before going into details, let’s make it clear that SECC, at its core, offers equity of a company to an external entity. As a result, the external entity stays on the capitalisation table from this point on until they cash out from their position. Given the timing nature of SECC, these parties would be among the first to be on the cap table.
Therefore, any general advice about how a startup manages its cap tables applies. In particular, think carefully about who you want to be engaging with when using SECC: Do they provide more value in the long run? Are there other reasons why they should be on the cap table? Some degree of due diligence is also recommended, for both sides.
Scenarios for founders
A typical scenario where founders may not want to go ahead with SECC:
- Engaging a dev shop for the initial prototype or MVP: there is a place for those dev shops that provide a vital service to startups who may not have enough technical know-how to deliver their first working product; however, they cease to provide any value post-investment when usually a product team is set up within a startup;
And a typical scenario where founders may want to:
- Engaging a potential co-founder or somebody you would like to hire later: the contracted work becomes a trial project or probation of what could come after the contractor joins as a member of the team; the use of equity here has the same positive effect as offering share options to (early) startup employees.
Somewhere in between sit the venture builders or startup studios which are the companies helping founders build products at the early stage. The deciding factor is their ongoing support and value-added beyond the initial engagement period.
Sometimes the constraint on cash prior to any significant funding takes precedence over concern on cap table composition, using an SECC to fund the early stage of a startup becomes the only way to get there. Even in this case, founders should ensure contractors engaged in this manner would unlikely become a detractor to future fundraising.
Considerations for contractors
SECC is a risk-sharing arrangement. Contractors willing to engage in the negotiation should have some degree of risk tolerance. Most startups fail; especially at this early stage, the failure rate can be exceptionally high. Like what investors do, contractors should adopt a similar methodology in picking founders to work with.
Once accepting the risk, the considerations can be more tactical:
- How much upfront cash do you need, which may affect your operating cash flow;
- How much equity are you looking to acquire;
- Other than cash and equity, do you intend to work with the founders post the next priced round, i.e. is there more to the equity-for-cash scenario?
Once both parties are clear about the implications and still decide in favour of using SECC, it’s time to look at the details of setting up an SECC.
How to compensate for somebody’s contribution fairly is the challenge to tackle here:
- In general, cash compensation is easy to decide on, usually based on a cost per time-unit such as hourly or daily rate, a.k.a contractors’ rate and how much time is expected to accomplish the work.
- On the other hand, giving out any equity in a startup company is never easy. There are some useful calculators helping co-founders split equity at the start of the journey, based primarily on their skill and experience, plus their expected input.
These are two different methodologies and any attempt to mix both into a compensation structure would make it even more difficult.
What is used here, in the contractors’ context, is to decide on the total cash compensation first, and then use a sliding scale to add an equity component, all the way until the cash component becomes zero. The result is a calculation that slides between 100% cash compensation and 100% equity compensation, based on a pre-determined all-cash compensation figure.
Calculation in detail
In its purest form, it is a labour contract that obligates founders to compensate contractors for the work they carried out. There is always a cash number to represent the payment due, usually using an agreed market rate, as mentioned earlier in the methodology. Let’s call it
Between the two parties, they need to decide how to structure the compensation.
- In a full-cash scenario, the cash value C becomes payable in full.
- In a full-equity scenario, nothing is payable.
- In a part-cash-part-equity scenario, a portion of C becomes payable.
In order to model all the scenarios above, let’s introduce a variable
P which is the percentage of upfront payment out of the total payment due.
- In a full-cash scenario, P = 100%
- In a full-equity scenario, P = 0%
- P is somewhere between 0% and 100% for any part-cash-part-equity scenario
It is now straightforward to derive that once the upfront payment of
C * P
has been paid out, the remaining balance of
C * (1 - P)
is due at some point in the future.
This is triggered by the next priced round, i.e. a round of fundraising that comes with a valuation of the startup. At that point,
- The valuation
Vvalue becomes known;
- The “convertible” feature takes effect, meaning that:
- If contractors choose to take cash, then the remaining balance becomes payable immediately;
- If contractors choose to take equity, then their ownership is calculated and put on the cap table along with other investors.
A simplistic calculation for contractors’ ownership when converting to equity is
C * (1 - P) / V
which could work for some but lacks the flexibility of tweaking the final ownership, as well as protection for both parties in the extreme events of a valuation too much lower or higher than expected.
To improve, a multiplier
M is introduced to inflate the convertible cash amount (mathematically it could also deflate if M < 1). Furthermore, valuation caps can be set for both a floor and a ceiling amounts,
FLOORv value and
CEILINGv value respectively. All of those values need to be agreed upon by both parties. Now the calculation becomes
C * (1 - P) * M / Ev
where the effective valuation
Ev = max(min(v, CEILINGv), FLOORv)
i.e. capped on both ends.
The existence of M (when > 1) is to sweeten the deal by artificially inflating cash owed to contractors who effectively use the inflated amount to invest in this round. Caps are set up to protect both parties from over- or under- dilution.
More details on M value and all the valuation-related values will be covered in the strategies section below.
With the formula laid out, let’s reason about the benefits of adopting SECC.
For founders: preserving cash
At this point of the startup journey, founders are likely to self-fund, which means the budget can be tight. Making the best of limited cash becomes an important strategy until the situation changes, usually as a result of a major funding round. SECC helps get things done at a much cheaper cost.
For contractors: speculating on growth
For those who are used to working with startups, they tend to have a higher degree of risk acceptance. In this typical risk-reward situation, there is rarely anything better than having your downside covered while keeping unlimited upside. The upfront cash payment is the downside protection, and the convertible equity at the next priced round gives the exposure to the upside, which can be lucrative. It also gives contractors options: in some occasions taking the remaining cash may be a better option for various reasons.
For both parties: only the beginning of a long-term collaboration
Whenever somebody appears on the cap table, they are in for a long ride. The same goes for contractors here who at this earliest moment, decide to be part of the startups’ journey, by taking equities instead of cash. It is a plausible act but with any investment, it should be a mutual decision based on the match from both parties.
As mentioned above, there are scenarios where entering into an SECC is not desirable.
Strategies for setting up SECC
Be aware that the
C value may not be a constant
It is common to agree on a fixed payment for a project, which is the C value mentioned above. However, with an ongoing contract running towards an uncertain fundraising date, the C value is more likely to be calculated using an hourly/daily/weekly/monthly unit rate timed by how many time units run up to actual fundraising, which is the conversion date. In this instance, C should be replaced by a unit price U with a number of time units T, i.e.
C = U * T
It would create uncertainty in the final equity grant to contractors as the calculation becomes a partial function of the time T. My suggestion is to introduce caps around T to regulate equity grants, with the same effect that the valuation floor and ceiling have.
P value according to contractors’ risk appetite
As mentioned above, P can be 100% which makes SECC the equivalent of a normal labour contract, or 0% which makes SECC a pure sweat equity agreement. 50% is the norm, and there are a few reasons to start with it:
- If the market rate is used to decide on the C value, assuming these contracts are for tech roles, 50% of the C value would still be close to the living wage level; if there’s any concern about minimum wage in certain countries, my suggestion is to use minimum wage as unit rate to arrive at P value. In effect, the P value is the indicator for asset allocation if you treat this as an investment portfolio. The higher P is, the more cash is held therefore less risky, and vice versa. It is the contractors’ call to make it a reflection of their risk tolerance level. 50:50 is usually the place to start.
- Given the early-stage startup context, setting the P value too high may not make sense. Again if we treat this as an investment portfolio, and comparably there is another “trade” against a blue-chip company with a perfect payment record, i.e. P = 100% with no risk at all, it is preferable to pick that blue-chip contract over this startup one. It is to say that one of the major reasons contractors pick this is because of their high risk-tolerance. Setting the P value too high defeats that purpose.
- Also explained in the previous section, founders would probably prefer anything under 50% for P value so that there would be a meaningful preserving effect on cash burn.
- In a similar vein, contractors should also be cautious about setting the P value too low. If the upfront cash payment becomes insignificant as a result of a low P value, SECC would have lost one of its two attractions: the downside becomes exposed because of not enough cash payment to cover it.
(Excuse my laborious writing as it quickly turns into Investment 101, which confirms the significance of the P value.)
M value wisely
M is the gift or reward that founders are willing to offer to contractors, for them to share the risk.
It is usually the key number for negotiation. To arrive at an agreeable value, my suggestion is to experiment with a few M values to look at the corresponding equity grants and pick one that makes the most sense to both parties.
In theory, M can be less than 1 or even go down to 0. It may make sense in some circumstances but navigate your way wisely.
Always set a floor
FLOORv and a ceiling
CEILINGv for valuation
The ceiling value is there to protect contractors from being overly diluted if the startup raises at too high a valuation.
The floor value is there to protect founders from giving away too much equity, in case a low valuation is used in the priced round.
With both a floor and a ceiling, it gives a range of the equity on offer, decided by the two valuations inversely. The certainty is always appreciated by both parties.
Make clear whether the valuation is pre- or post- money
This is for contract hygiene. As long as the correct pre- or post- money valuations are used in the calculation, pre- and post- figures should end up being consistent.
I personally prefer using post-money because it is more relevant to the current state of affairs.
The unknown: tax implications for contractors
I am NOT a tax adviser. I have absolutely no idea about the tax implications of this arrangement. What I could suggest is to look to tax treatment for convertible notes in the contractors’ country of tax residency for some initial understanding.
Always consult a qualified tax professional.
Variants: expiry, interests and valuation discount
These sometimes find their way into a convertible note. They can be included in SECC too if so desired. However, having them would complicate the calculation.
Variants: vesting schedule
The equity portion of the contract can have a vesting schedule attached. However, a normal employee vesting schedule is usually not suitable because of the 1-year cliff that goes against the fact that contractors have already worked with founders leading to the fundraising.
My suggestion is to play with both the M value and a vesting schedule together. A higher multiplier / M value sends the signal that founders are willing to give away more equity; in this scenario, it is also easier to argue for a portion of the equity to be vested immediately, with the rest subject to linear vesting, e.g. monthly with no cliff for a shorter period of time, e.g. 1-2 years instead of 4.
This post would not be complete without a ready-to-use calculator.
Make a copy of the calculator (Google Sheet) and experiment with your own calculations.
This work is licensed under a Creative Commons Attribution-ShareAlike 4.0 International License.
Call to action and help
Now you have the calculator and know how to use it. Please do share it with your peers if you find it useful for them too.
One more favour to ask: I’m looking for a legal professional to incorporate this into a free contractor/advisor/NED agreement template so that it helps early-stage founders to navigate through the legal maze (and save money too).
Thanks for reading and good luck with your startup journey!