What Is Sweat Equity And How Does It Work: Everything You Need to Know
What is sweat equity and how does it work? Sweat equity is the type of investment that measures time and effort put into a project. 3 min read
2. How to Determine the Value of Your Sweat Equity
Updated July 7, 2020:
What is sweat equity and how does it work? Sweat equity is the type of investment that measures time and effort put into a project. It is the ownership interest or increased value that results from the owner's hard work. In startups, sweat equity may be the biggest contribution of founders who may not have the cash to contribute.
The Importance of Monitoring Sweat Equity
Sweat equity is especially valuable in startups whose founders may not have a lot of cash to hire employees, consultants, and service providers. The founders or the few employees perform activities that would otherwise be done by employees, consultants, or service providers. For example, the founders of many tech startups cannot afford to pay advertising agencies, so they do the advertising work themselves.
This toil or sweat equity in such cases is crucial to the survival of the company and may yield results when the founders eventually sell the business to a larger company. In the real estate industry, sweat equity is a measure of the improvement made by property owners to the property.
- It is important for both the founders and investors in a business to account for the sweat equity of the founders. This can help them to analyze the financial health of the business.
- It may also come in handy when the founders of a business have to sell shares to investors. Sweat equity enables companies to get funds without incurring debts. They do this by selling a portion of the company to investors, hence getting the funds needed for business operations.
- Monitoring sweat equity from an early stage may help to prevent future conflicts in companies that have multiple founders.
For example, a business owner whose initial investment in her startup was $30,000 seeks to sell a stake in her startup. She values her business at $1 million and wants to sell a 30 percent stake to an angel investor. That leaves her share of the business at $700,000. Her sweat equity is the value of the business without her cash contribution, an equivalent of $670,000.
How to Determine the Value of Your Sweat Equity
Sweat equity is a component of a company's worth. Finding out the exact worth of a person's sweat equity is not easy. It is not an exact science but business owners should determine the value of sweat equity as early as possible. This can be done using the following steps:
- Determine the value of the business. It is important for the business owner to first determine the value of the business. This can be by determining the amount of startup capital injected into the business or by comparing with similar companies on websites like BizBuySell and BizQuest. You should be careful to only compare with companies in the same geographical location and industry as your startup. The value of the business can also be determined using discounted cash flow.
- Determine the stock value of the business. It is important to know the value of each share or each partner's interest percentage.
- Determine sweat equity. It is important that the amount assigned to sweat equity is an accurate representation of real-world conditions. You can determine the value of sweat equity by finding out what each person would have been paid if he did the same work for another company. But sweat equity normally contributes more to the value of the company than just the labor hours involved. Depending on the industry in which the company does business and the unique situation of the company, it is normally necessary to include an allowance in addition to the labor hours.
- Pay the individuals who contributed the sweat equity. To pay the individuals who contributed the sweat equity, the share price or unit value of the company is multiplied by the monetary amount for the labor performed to get the sweat equity value for that person. For example, if a corporation's share price is $10 and a person performed work worth $100,000, that person did work worth 10,000 shares. A similar method is used for LLCs and partnerships, but calculations are made using membership interest instead of shares.
If you need help to determine the value of sweat equity in your company, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.