What Is Sweat Equity?

Sweat equity can be used to pay employees, increase the value of a company, or make improvements to real estate. It can buy you skills and talent you might not otherwise be able to afford as a startup. It might get you more investor funding than your business could otherwise fetch based on its sales. And it can increase the profit from the sale of real estate property.

But it's important to go into a sweat equity arrangement with eyes wide open or you might find that you've given up more than you've received.

What Is Sweat Equity?

Sweat equity is a way of assigning a dollar value to work, expertise, or time when money is in short supply or when the dollar value doesn't reflect the full value of a venture or a project.

Employees given stock or options instead of wages are being paid in sweat equity. Entrepreneurs use sweat equity to value the time and effort they put into creating their business. And real estate investors use sweat equity to get bigger returns from the sale of a property by doing repairs and renovations themselves.

How Does Sweat Equity Work in Startups?

Let's say you've got the world's best cookie recipe, handed down from your grandmother, and you have a plan to create the next great cookie company. You are expert at making the cookies. You have a supplier with the best ingredients, an agreement with a premier commercial kitchen, and a truck to deliver the cookies to retailers.

You need packaging and marketing to get your business off the ground, but you've gone through your savings and your business isn't generating sales yet. You don't have money to pay a salary, but your best friend from college is the director of marketing and design for a well-known packaged goods company. The two of you decide to join forces and you agree to give your friend a stake in the company instead of a salary. You've just used sweat equity to provide your company with top-notch expertise before you even sold your first cookie.

Now suppose that you need additional funding to put the packaging into production and launch an advertising campaign for your cookies. The sweat equity deal you just made with your best friend can also help you to raise additional funding from outside investors because your company is now worth more with packaging and marketing expertise added than it was before.

How Is Sweat Equity Calculated?

Calculating the value of sweat equity is a judgment call and there is no set formula, especially if your business is not yet generating any sales.

Let's figure the business owner in our cookie company example invested savings of $100,000 to start the business and estimates the time and effort involved in writing a business plan, researching ingredient sourcing and kitchen facilities, and making supplier and retailer connections is worth an additional $100,000. The business would have a value of $200,000 according to these estimates.

Our business owner might say that the best friend is giving up an annual salary of $50,000 to come on board and, based on the $200,000 value of the company, is entitled to a 25% ownership stake. The employee might think packaging and marketing expertise is worth more and ask for a larger stake. Or they both might agree that packaging and marketing is so essential to the success of the company that the best friend's sweat equity is worth a full partnership with a 50% stake. Some owners decide to pay a portion of the wages in dollars to reduce the sweat equity to a smaller percentage of ownership.

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

Calculating the value of sweat equity when you are looking for investors can be even more challenging because sweat equity is only worth what an investor is willing to pay.

Let's go back to our cookie company example. Before your friend joined, you estimated the company's value was $200,000 and an investor who wanted a 20% stake would have to pay you $40,000 for that stake.

Now let's assume your best friend agreed to your sweat equity proposal and is now on board. You have a package design and a marketing plan in addition to a killer recipe, baking expertise, a production source, and a delivery vehicle, and you estimate your company is now worth $300,000 with the added expertise. The same investor who bought a 20% stake for $40,000 would have to pay you $60,000 for that same percentage of the company due to the increased sweat equity.

But before you put that extra $20,000 in the bank, you're going to have to find an investor who agrees with your estimates because sweat equity is only as valuable as what an investor is willing to pay.

Sweat Equity in Real Estate

A homeowner or real estate investor might also use their own labor and efforts in making repairs and renovations on a property to increase the sale price.They might choose to build a deck or remodel a bathroom themselves instead of hiring a general contractor or other professional, for example, and add in their labor and time when they set a sale price.

As with a business venture, a homeowner or investor will only receive an added return if a potential buyer agrees that their efforts added value. If the work doesn't end up looking professional, the sweat might not result in more equity.

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 a Motivational Tool. In addition to giving owners access to skills that might otherwise be unaffordable, sweat equity can also create more motivated employees because they are sharing in the success of the company. But it's important to make certain that employees have the means to wait for their equity to pay off. The equity on a company that's not making any profit is zero, and it could take years for the equity to provide a living wage. Employees who need money to live on might not be able to devote their full attention to the venture in the meantime or they could lose interest and move on.

Giving Up Equity Means Giving Up Control. Giving away a percentage of the company also means giving up some control over how the company is run and decisions that are made. It's important that sweat equity partners see eye-to-eye and share common goals and commitment to the business or the company might flounder.

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.