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Structuring and Issuing Sweat Equity for Startups in Malaysia

Sweat equity is a form of equity compensation where a recipient receives company shares in exchange for his or her time, skills, and effort.  While sweat equity offers a valuable tool for attracting talent and incentivizing founders, proper structuring and issuance are crucial to avoid future legal hassles down the line. 

1.  Defining the “Sweat”

The first step is to define what constitutes “sweat” in your agreement. Founders should agree on the expected contributions to avoid disputes later. If you are onboarding an adviser or a mentor, it is better to mention in the agreement the actual time that you expect him or her to attend meetings (i.e. allocate at least 4 hours a month rather than just generic wordings like attending meetings etc). As a legal counsel, we will also encourage the drafting to include the duration, specific milestones, or a combination of both.

Also, sweat equity should determine the value of the “sweat” in ringgit value. For instance, you may pay a CTO candidate a salary of RM10,000 a month, or  alternatively compensate him or her by issuing the entire RM120,000 in new shares as sweat equity. Or it can be a combination of salary and sweat equity. 

2. Valuation: Setting the Share Price

Another crucial element when it comes to sweat equity is to determine the valuation of the company. Ordinarily, sweat equity shares are expected to be issued at a pre-money valuation (i.e. the share price before any external investment). This valuation usually reflects the company’s value based on its initial concept and founding team (which is often a lower price point, rewarding early contributors). In practice, this valuation may likely be determined by the first institutional investor i.e. like a venture capitalist that makes a cash investment in the company. 

However, startups often lack a readily available valuation. Another option is to defer the shares allotment for the sweat equity until there is a priced round so that the sweat equity shares may be issued at or before the funding round. The implication to this agreement may give the same legal effect of deferring the shares allotment at a later date such as  an investor that has invested in a company using the ‘Simple Agreement for Future Equity’ (‘SAFE’) instrument). 

3. Vesting Schedules: A Gradual Ownership Climb

Vesting schedules establish a timeframe over which sweat equity recipients may receive full ownership of their equity stake. Generally, we urge founders to implement the usual vesting schedules practised in Silicon Valley startups. The shares usually vest from year 1 to year 4, with a “cliffs” (i.e. periods where no shares vest) at the beginning to discourage short-term involvement.

 This incentivises long-term commitment and reduces the risk of early departures with valuable company knowledge.  Depending if the departure is on a “good leaver” (i.e. events that encourages executives to remain with the company) or “bad leaver” (i.e. events that cayuses the receipts to leave the company under unfavourable circumstances like a criminal breach of trust),  scenario, the vesting provisions should outline how both of the vested shares or unvested shares  will be treated prior to the departure.

4. Issuance Mechanisms: Choosing the Right Vehicle

Sweat equity can be issued through different mechanisms depending on your commercial preference.

Employee Shares Option Scheme (‘ESOS’): These grant the right to purchase shares at a predetermined price within a specific timeframe in accordance with an ESOS by-laws / rules to be adopted by the company. This allows recipients to benefit from potential share price appreciation while protecting the company from immediate dilution. In practice, we may likely expect ESOS to be adopted as a prerequisite by an institutional investor i.e. a VC prior to the investment (by the said VC).

Direct Issuance of Shares:  This option may likely be most preferred by the recipient, as this option grants immediate ownership with vesting schedules. However, the new shares issuance may likely dilute existing shareholders more and requires additional paperwork including statutory lodgement for new shares.

You may come across terminologies like “Restricted Stock Units (‘RSUs’)” which may likely be the common phrase used overseas. However, in Malaysia, the usual industry practice is when the shares are issued upfront, the recipient (i.e. the new shareholder) will agree that his or her shares may be subject to vesting schedules.  Essentially, vesting is a contractual agreement of transferring or selling shares to a recipient after such recipient achieving certain conditions or achieving certain pre-agreed results.

5. Legal Documentation: Sweat Equity Agreements

A sweat equity agreement is crucial for clarity and protection. The following are the usual terms that should be considered carefully:

  • Parties Involved: Names and roles of the company and sweat equity recipients.
  • Services Rendered: A detailed description of the expected work or contribution.
  • Valuation Method: How the share price is determined.
  • Vesting Schedule: The timeframe for earning full ownership.
  • Issuance Mechanism: The chosen method for issuing shares (options, or direct issuance).
  • Confidentiality and Non-compete Clauses (optional): To protect sensitive company information and prevent competition if recipients leave.

Additional Considerations

As a recipient, other considerations may include looking at any tax implications when you receive or liquidate the equity stake as capital gains tax. Sweat equity recipients may incur tax liabilities upon vesting as it may usually termed as an income. Consequently, you would need to seek tax advice on how to receive the sweat equity stake properly.

Additionally, depending on the  terms of the existing shareholders agreement, prior consents from the existing shareholders would likely be needed to waive their preemptive right to subscribe to the new shares to make way for the sweat equity recipient.

Conclusion

Sweat equity can be a great corporate tool for startups, attracting talent, aligning interests, and fostering ownership among key contributors.  However, careful structuring and issuance are essential to ensure fairness, compliance, and avoid future legal disputes.   

As your startup lawyer, we have guided founders in the past, ensuring a well-defined sweat equity programme for talents that will contribute to your company’s growth and success.

Disclaimer: The content provided on this website does not constitute legal advice but are for general informational purposes only. It may not be the most up-to-date legal information after the published date. To seek professional legal advice, please book in a free initial 30 mins legal consult with us.

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Izwan Zakaria

Izwan likes to write about startups. He enjoys working and mentoring entrepreneurs and founders. He is also a startup lawyer at Izwan & Partners.

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