What is Sweat Equity?
Sweat equity is a non-monetary contribution that the individuals or founders of a company make towards the company. Cash-strapped startups and business owners typically use sweat equity to fund their companies.
For example, the founder of a tech startup company may value the efforts placed towards developing the company at $200,000. If an angel investor is interested in investing in the business, the founder may sell a 25% ownership of the company at $1,000,000. The stake places the company at a valuation of $4,000,000. After selling the 25% stake in the company, the founder remains with $3,000,000. After deducting the contribution to the company of $200,000, the founder benefits from a $2,800,000 sweat equity.
In a partnership, the initial partners may get a sweat equity share of the company, while requiring any future partners to pay a financial capital. The sweat capital is valued in terms of each partner’s effort and hard work in building the business. Also, in early-stage companies, employees may receive stock options as a reward for accepting below-market rate salaries. Such a scenario may occur when a company shows considerable potential for growth but lacks enough funds to pay employees. The stock options plan gives the employees a part-ownership of the employer’s company.
How to Calculate Sweat Equity
Since sweat equity does not represent financial commitment in a business, one must value the amount of time spent on an activity or in developing the business. For example, the owner of a tech company may value the time spent drawing the business plan and designing a software at $100,000. The company’s employees may also estimate that they spent $50,000 worth of their time in building the company, and which the owner may not be in a position to pay. Fixing the company’s value at $150,000 does not necessarily mean that it is the company’s actual value. In essence, it could be worth more than that.
If the company gets an investor willing to invest $1,000,000 at 25% equity, it places the company’s valuation at $4,000,000. The owners get $3,000,000 of free money from the valuation, which leaves them with $2,850,000 after deducting the initial costs. If the company measures its valuation in terms of share of stock, the value of each share must be determined before deciding the number of shares to allocate to the person performing the sweat equity. For example, if the company is worth $150,000 and it has issued 10,000 shares, then each share is worth $15. If the person who performed the sweat equity delivered work worth $30,000, the person should be paid 2,000 shares of stock. If the business is a limited company or partnership, the person who performed the equity in effects gets an ownership percentage in the company.
Importance of Sweat Equity
Sweat equity compensates for the shortage of cash. The founders of start-up companies are often disadvantaged by the lack of funds to finance their activities. However, they devote their time to grow the company through effort and toil, which are rewarded back when the company becomes profitable. In real estate, poor households often lack the funds to build their own homes but got a lot of free time on their hands. They can dedicate their time to building their own homes and those of their neighbors. They also pay fewer mortgages than they would’ve paid if they purchased the houses.
Also, sweat equity is as valuable as cash equity. Often, large investors invest their money in small but growing companies with the potential to become large companies in the future. The employees who take a pay cut at the early stages are rewarded through stock options and ownership percentages that place them on the same page as cash equity investors. In real estate, some owners make DIY improvements on old houses and sell them at a higher market value than their value before the renovations.
Sweat equity allows companies to raise funds without raising debt levels. Startup companies often face challenges in raising capital and obtaining too much debt may cripple the business. Sweat equity provides them with a platform to get “free money” by selling a portion of the company to investors. For example, a founder may value the time spent in growing the company at $100,000 but sell 25% of the company to an investor at $1,000,000. The valuation puts the company at $4,000,000, giving the founder $3,000,000 in free money.
Sweat Equity in Real Estate
In the context of real estate, sweat capital refers to the value of unpaid work that results in a market rate value increase in the property price. The more improvements are added to a house, the more sweat equity is added and the greater the value of the house. An example of sweat equity is a person who spends time renovating homes and selling them at a higher price. The difference between the value of the home before renovations and the market value of the home after repairs represent the sweat equity.