What Does Sweet Equity Mean?
Sweet equity is a type of financial instrument that represents any form of non-monetary equity that the owners or employees of a business contribute to the venture. Sweet equity can come in the form of options, rights, warrants, restricted stocks and RSUs or other forms of equity.
Sweet equity is most often used by startup companies that are short of cash to reward employees and owners. Various forms of equity are issued depending upon the performance of the company/investment and the level of success that it achieves.
In most cases, sweet equity is only issued to the company’s management team when there is a leveraged buyout (LBO) with a private equity partner. The sweet equity shares are then issued with an exercise price that is less than the current market price, thus incentivizing the company’s management to make the company profitable. These shares then stand to promise the management a greater share of the company’s equity profits when it is sold.
Divestopedia Explains Sweet Equity
The owners and key employees of many startup companies pour their time, talent and skills into getting the company going. They do this out of passion for the business and with an eye to making a profit on their shares when the company is sold. Since the company may not have the cash necessary to adequately compensate these employees, it can use sweet equity to reward them proportionately to their level of contribution. This allows key employees and top management to reap greater profits than rank and file employees. This effectively ensures that employees are rewarded according to their efforts to get the company off the ground and make it a profitable entity.
For example, the company’s owners and directors may get shares at a discounted rate in return for their dedication. In many cases, this type of discounted share may be issued when the company meets certain performance targets, such as earnings per share, performance of the company related to a benchmark index or overall return on equity. These performance benchmarks are typically measured over a period of years.
The management team usually cannot get its hands on the sweet equity shares until after the investor (typically a private equity fund) reaps its required share of the profits. In most cases, the amount of profit required by the fund will be an Internal Rate of Return of 30%. The management team needs to work with the investor to determine how various types of strategies and transactions will affect the IRR. Factors such as additional equity issues, refinancing, dividends, partial sales and fees and other items should be negotiated with the seller in order to avoid any potential disputes at a later point in time.
The private equity firms that are looking at buying the company may stipulate that the management teams in the companies that they acquire retain a small stake of ownership for the sweet equity employees. This can help to ensure that the management teams assist the sweet equity employees to reach their financial goals.