What is Sweat Equity?
Sweat Equity refers to the contribution being made by owners and employees towards the company in the form of consideration other than cash. It is beneficial for start-ups who do not have enough hard money to invest in the operation of a business.
For example, let’s take a partnership firm where some members contribute in the form of cash, and others contribute their time and efforts towards the common objective of the firm. Therefore, we see there are two types of contributions towards the capital of the firm one is cash and other is sweat equity in the form of time and effort. It is counted equivalent to the cash equity and distributed in the form of equityEquityEquity refers to investor’s ownership of a company representing the amount they would receive after liquidating assets and paying off the liabilities and debts. It is the difference between the assets and liabilities shown on a company's balance sheet. stock to the owners and employees.
How Does Sweat Equity Work?
Let’s say that Mr. Stuart has started a company named VVC Ltd. Mr. Stuart doesn’t have a lot of capital to invest in the company. So, he decided to start VVC Ltd. at $10,000. He decides that during the initial period, he would hire employees on sweat equity and then once he gets an investor, he would pay them in full.
So, after a few years of hard work, Mr. Stuart and his employees created a company that generates handsome revenue per year. The angel investor wants to invest 0.5 million for 25% stake. From the valuation of the angel investorAngel InvestorAngel investors refer to wealthy investors who supply capital to budding businesses in return for a portion of their equity. , we can understand that the company is valued at $2 million.
Now, stake of Mr. Stuart is worth = ($2 million * 75%) = $1.5 million.
His initial cost of investment was $10,000. That means he has the free money of $1.49 million.
But the valuation of the company can be much more than that.
The question now is that how much sweat equity would be assigned to the employees before getting the angel investor?
The answer is in the valuation of the companyValuation Of The CompanyDiscounted cash flow, comparable company analysis, comparable transaction comps, asset valuation, and sum of parts are the five methods for valuing a company. at the date when the employee is hired. Let’s say Mr. A was hired during the initial days of Mr. Stuart’s business. Mr. Stuart could only source a few clients at that time, and the value of his company at that time was just $100,000. If we decide upon a number, let’s say 20,000 shares as the total sweat equity of the company; we get each share at $5 at that time.
Now if Mr. Stuart feels that Mr. A would be doing work worth $10,000, he would be given 2000 shares of the company.
That is how the sweat equity is calculated and assigned. If the company is a limited liabilityLimited LiabilityLimited liability refers to that legal structure where the owners' or investors' personal assets are not at stake. Their accountability for business loss or debt doesn't exceed their capital investment in the company. It is applicable in partnership firms and limited liability companies. or a partnership company, doing this will provide the employees with an ownership in the company.
- Sweat equity is as valuable as cash equity. You may think that since we’re putting in the effort and toil, it may have less value, but ask any business owner or a real estate agent. They would tell you that because the homeowner put in the effort for making improvements for his house, the house can be sold at a decent profit over and above the normal price of the house. A business owner knows the value of sweat equity because, at the beginning of running an enterprise, the majority of her focus should go on the effort and toil she puts in (for money to come in).
- Sweat equity is useful when cash isn’t enough. This is just the extension of the earlier point. In the beginning, a business owner doesn’t have a lot of money. But they have a lot of time. They can put in the effort during the time and can earn cash when cash isn’t enough.
- Sweat equity can be paid back in future: When a company starts its journey, it hires employees stating that they would be paid sweat equity. What does it mean actually? It means that the owner knows the value of the effort and the time of his employees. But since there’s no cash coming in, the employees can be paid in sweat equity, and when the business would receive the money, the employees would be paid based on its value (if they want to sell their stakes).
- The exact valuation of sweat equity is difficult as it is a non-monetary commitment made by its owners and employees. The owners stand to lose when the investors do not value their contribution by offering the valuation much lower than which could be a detriment for them at the same time.
- Owners strive to maximize the value much greater than the market, which failed to meet the owner’s expectation by offering them lower value. Owners should make sure that they should make an agreement to ward off any conflicts for the valuation of the business.
- The valuation could be negatively impacted by the length of sweat equity being contributed over a long period of time.
This has been a guide to what is Sweat equity and its meaning. Here we discuss how it works along with its importance and disadvantages. You can learn more about finance from the following articles –