What Is Sweat Equity and How Does It Work?

Sweat equity can bring essential resources to a struggling business, but make sure you assess the benefits and drawbacks.

Sweat equity can be utilized to compensate employees, boost a company's value, or make real estate upgrades. It can help you acquire talents and talent that you otherwise wouldn't be able to afford as a startup. It may help you get more money from investors than your company could normally raise based on its sales. It also has the potential to improve the profit from the sale of real estate.

However, you must enter a sweat equity agreement with your eyes wide open, or you may find that you have given up more than you have earned.

What is Sweat Equity?

When money is scarce or the dollar value does not reflect the whole value of a business or project, sweat equity is a technique of giving a dollar value to effort, skill, or time.

Employees that are paid with sweat equity instead of salary are given stock or options. Sweat equity is a term used by entrepreneurs to describe the value they place on the time and effort they put into starting a firm. Real estate investors can also employ sweat equity to increase their profits from a home sale by performing repairs and upgrades themselves.

How Does Sweat Equity Work in Startups?

Let's imagine you have the best cookie recipe in the world, passed down from your grandmother, and you're planning to start the next big cookie company. You've mastered the art of baking cookies. You've found a supplier with the best ingredients, worked out a deal with a top commercial kitchen, and have a truck ready to distribute the cookies to stores.

You need packaging and marketing to get your business off the ground, but you've spent all of your cash and your company is still not making money. You don't have the funds to pay a wage, but your best friend from college works for a well-known packaged goods firm as the director of marketing and design. You decide to team up, and instead of paying your friend a salary, you agree to offer him a share of the company. Before you even sold your first cookie, you used your sweat equity to provide your company with top-notch competence.

Assume you require additional funds to put the package into production and launch a cookie marketing campaign. Because your company is now worth more with packaging and marketing experience added than it was before, the sweat equity agreement you just made with your closest friend can also help you get further capital from outside investors.

How Is Sweat Equity Calculated?

There is no fixed formula for calculating the worth of sweat equity, especially if your organization has yet to generate any revenue.

Let's say the owner of our cookie firm put aside $100,000 to start the company and estimates that the time and effort spent creating a business strategy, investigating ingredient sourcing and cooking facilities, and connecting with suppliers and retailers is worth another $100,000. According to these calculations, the company is worth $200,000.

Our business owner may claim that the best buddy is giving up a $50,000 annual income in exchange for a 25% ownership stake in the firm valued at $200,000, based on the $200,000 value of the company. The employee may believe that his or her packaging and marketing knowledge is more valuable and request a larger stake. Alternatively, they may both feel that packaging and marketing are so important to the company's success that the best friend's sweat equity is worth a full partnership with a 50% interest. To lower the sweat equity to a lesser percentage of ownership, some business owners choose to pay a portion of the salary in dollars.

Sweat equity can also be paid with common stock shares and stock options using a similar formula, but regardless of the form of equity, the factors to consider include:

• What value is the employee or partner bringing to the company? Consider things that can't be measured such as relationships with potential investors and customers besides skills and responsibilities.
• Is the ownership stake enough to keep employees motivated? In general, the more skin in the game, the more motivated the employee.
• Are there emotional considerations such as family relationships involved? If your employees or partners are family members, keeping the peace in the family might be more important than keeping a bigger stake in the company.
• How much control are you willing to give up? Giving away 50% of the company also means giving up full control over decision-making unless you also arrange for more voting rights than your 50% partner.
• What long term gains will your startup receive from the employee you pay in sweat equity? Don't just look at the value of the interest you are giving up today. Consider what your interest will be worth as your company grows.

Remember that sweat equity is taxable, so you should be able to defend the way you calculate the value of sweat equity.

Calculating Sweat Equity for Investors

When you're looking for investors, calculating the value of sweat equity can be even more difficult because sweat equity is only worth what an investor is willing to pay.

Let's return to the case of the cookie company. You estimated the company's value to be $200,000 before your friend joined, and an investor who wanted a 20% ownership would have to pay you $40,000.

Let's pretend your best friend accepted your sweat equity proposition and is now on board with you. You have a killer recipe, baking experience, a production source, and a delivery vehicle, as well as a package design and a marketing plan, and you believe your company is now worth $300,000 with the extra expertise. Due to the additional sweat equity, the same investor who bought a 20% stake for $40,000 would have to pay you $60,000 for the same proportion of the company.

But, before you put that extra $20,000 in the bank, you'll need to find an investor who agrees with your projections, because sweat equity is only worth what an investor is prepared to pay for it.

Sweat Equity in Real Estate

To raise the sale price of a property, a homeowner or real estate investor may use their own labor and efforts to make repairs and modifications. Instead of employing a general contractor or other expert, they can decide to build a deck or remodel a bathroom themselves, and factor in their effort and time when determining a sale price.

A homeowner or investor will only get a bonus if a potential buyer agrees that their efforts contributed value, just like in a commercial enterprise. The sweat may not result in increased equity if the task does not end up looking professional.

Pros and Cons of Using Sweat Equity

• Sweat Equity Saves Cash. Using sweat equity saves cash that can be used for other operations making it most attractive to startups because cash is often in short supply.

• Sweat Equity Can Be Used to Motivate People. In addition to providing owners with access to capabilities that might otherwise be unavailable, sweat equity can also inspire employees by allowing them to share in the company's success. However, it's critical to ensure that employees have the financial resources to wait for their equity to pay off. A company that isn't profitable has no equity, and it could take years for the equity to offer a living wage. Employees who require money to survive may not be able to dedicate their whole focus to the endeavor in the interim, or they may lose interest and leave.

• Giving up control means giving up equity. Giving up a piece of the firm also implies relinquishing some control over how it is run and what decisions are made. It's critical that sweat equity partners see eye to eye and share common aims and commitments to the company, or else the business will fail.

What to Include in a Sweat Equity Agreement?

Any sweat equity agreement should be made in writing and include:

• what is being offered and what is being exchanged
• performance measures if any
• number of stock shares and terms and price for stock options, and
• vesting schedule for stock shares and options.

​​​​​​​​​​​​​​Yoel Molina, Esq. (AKA “Mo”)

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