How to Calculate Sweat Equity: A Guide for Small Businesses

sweat equity diagram

What is Sweat Equity?

via GIPHY

Sweat equity, in simple terms, is the value generated from the physical labor, mental efforts, and other forms of toil put into achieving the organizational objectives. You can value this non-monetary benefit in terms of time as well. The term “sweat” stems from the drops of sweat or perspiration generated from hard work. It is mostly seen in startups when the owners commit time and effort into creating their venture.

You can take the investment in a literal sense too. For instance, think of the owner of a house making repairs and fixes to the porch. Sweat equity is the value generated in terms of the physical labor that adds to the value of the house. Apart from work, you may provide sweat equity in exchange for expertise, intellectual property rights, market knowledge, and other valuable information and tools.

This guide on how to calculate sweat equity for entrepreneurs and small businesses will cover the following:

  • Definition
  • How to distribute shares
  • Advantages and Disadvantages
  • Why is it important?
  • How to calculate it
  • How to draw up a Sweat Equity Agreement

 

Let’s talk about Sweat Equity Shares

Employees receive these type of shares in recognition of their contribution and hard work. They receive these shares which act as an incentive for them to be loyal and continue being productive. You can allot these shares at a lower price or for other non-monetary considerations. There could be a lock-in period. Moreover, the share price is determined according to the company guidelines.

Shares are distributed for their value addition, knowledge and for agreeing to share intellectual property rights.

Who receives these Shares?

  •       Directors (independent, promoter, and full-time)
  •       Employees
  •       A company associate who has provided valuable information or help.

Important considerations before allotting these shares:

  1. The shares shall be allotted within a stipulated period, for instance, 1 year.
  2. In the same way, there will be a lock-in period after the allotment of sweat equity shares. For example, 3 years could be the minimum time after which you are able to liquefy the shares.
  3.  The shareholders have to decide to allocate the sweat equity shares.
  4. A registered valuer has to look into the valuation to make it as appropriate as possible.
  5. The annual report must contain full disclosure of the terms and conditions of the sweat equity shares.
  6. Maintain a book of accounts for these types of shares.

Some notable facts about Sweat Equity:

It is worth as much as Cash Equity: In cases like real estate, sweat equity has immense value. The toil put into renovating the property brings up the market value of the house.

It can be converted at a later stage: In the nascent stage, a company owner uses sweat equity to pay her first few employees. This is because there’s no monetary value generated initially. When the company does start generating profits, the employees have the option to convert their sweat equity into cash.

Non-monetary Commitment: This type of equity is non-monetary. Those who invest, invest through labor or mental efforts. Hence, there could be a possibility that the investment is far less or far more than what is cashed for eventually.

Low Long-term Valuation: If sweat equity is given out over a long period, its value could diminish.

 

Advantages

  • You save money in the beginning: By banking on sweat equity, you can avoid the obligation of paying direct money to your investors and other stakeholders. Think about it. If there are options to create software or get any crucial work done without having to pay salaries and wages, then why wouldn’t you take it?
  •  Creates mutual goals and objectives: Both founders and employees share a common vision and work towards it. 
  • Tax Benefits: Long-term campaign gains allow for taxable exemption.
  • A window for open resources and talent: You can lure bright minds to join you in creating value addition for your consumers. By assuring valuable contributors of the promise that your startup offers, you are guaranteed excellent productivity.
  • Acts as a motivator: Sweat equity can be an incentive for investors, partners, and employees to stay committed to their roles.
  • Employee participation: The owners of sweat equity shares, or in this case, the employees have the opportunity to make their voice heard. They can participate at annual board meetings and voice concerns regarding the governing of the company.
    Advantages and Disadvantages

Disadvantages 

  • Setting a value: It is tricky to set a value for sweat equity. This is due to several factors that have to be considered before putting down a number. To elucidate, you need to first take into account the value of the business. This can be determined through the cash flow.
    Secondly, compare your business with other similar entities and come up with an estimate. You could choose to look at the sales price of the value offerings. Go over your assets, both tangible and intangible, and add a suitable premium to that amount.
  • Can lead to controversy: This point stems from the above. Since there is no concrete determiner for the valuation of sweat equity, altercations could arise.
  • False promises: The management may say something at the beginning and fail to keep their word during the time of evaluation. This is a common occurrence as seen in startups.
  • Potential for exploitation: Sometimes, employees are exploited in the name of sweat equity. They have massive workloads, immense accountability but very little ownership. Often, the workers do not get the amount originally decided or are paid unjustly.

 

Why is it important?

The concept of sweat equity is as important as money equity. The promise that a venture will turn into a booming business is what gives investors the confidence to back the enterprise. 

Sweat equity comes in handy during a financial crunch. Founders of a business enterprise can bank on sweat equity in difficult times. Consequently, this removes the pressure to pay stakeholders regularly. So the entrepreneurs can devote their time and efforts to concentrate on what really matters – getting the business up and running.

As sweat equity shares are valued at a lower range, you can keep financial debt under control. The investment process is smoothened out with this option. Furthermore, it could be thought of as “free money” received for selling a part of the company. 

There are people who accept meagre salaries in exchange for stocks and part ownership. This places them at par with capital investors. Additionally, sweat equity investors also receive the right to partake in important business decisions.

 

How to calculate the value of sweat equity

The value of sweat equity depends on how much the investor is willing to contribute. There are a few pertinent points to consider before zeroing down on the value of your sweat equity.

  • Study the economy in general. Get a basic outlook of the current and future conditions that have the potential to affect your business. Make sure to do thorough industry research as well.
  • Needless to say, it’s always wise to scan your competition. This would help you discover your edge and make you stand apart from the crowd. Again, your competitive edge would also stand you in good stead when you pitch to your sweat equity investors.
  • Your aptitude for management and potential or present clients. You should be able to determine the promise these stakeholders offer and whether you can bank on them on rainy days.
  • The company’s performance. A no-brainer, your investors have every right to know the potential your start-up has and the value you’d be giving back to them.
  • Note the contribution of the people towards sweat equity. Multiply the price of the share with the financial worth of the individual’s contribution. For example, if a worker is worth CAD 10000, and the share price is worth CAD 5, then the sweat equity, she will receive is CAD 50000.

Valuation of Sweat Equity- PLI

 

Let’s look at the valuation for two broader types of this form of equity.

A. Valuation for Startup Sweat Equity

As an example, let’s take Robin, a talented chef who has been working for 7 years at Four Seasons Resort Whistler. Now she wants to start her own chain of restaurants and has an initial capital of CAD 100,000.

Since she doesn’t have more money to spare, Robin decided that during the initial period she would be hiring employees on sweat equity and once she manages to land an investor, she will pay them in full. 

Now 3 years down the line, Robin and her employees have created a successful chain of restaurants that generates a handsome revenue per year. She has also managed to get an offer from an Angel Investor Ted who wants to invest CAD 500,000 for a 25% stake in her company. Hence, if we had to evaluate Ted’s worth here, we can understand that Robin’s company is now worth CAD 2,000,000. 

So, the stake of Robin herself is now CAD 2,000,000*75% which is CAD 1,500,000. Her initial investment being CAD 100,000, she has now made a profit of CAD 1,400,000.

However, the valuation of her company may be way higher. Now begs the question, how much sweat equity can be assigned to an employee before getting the Angel Investor Ted on board? 

The answer to that question is the valuation of Robin’s company on the day she hires that employee.

For instance, if she hired Lily and Marshall as a waitress and a janitor respectively on the same date and the valuation of her company as per that date is CAD 500,000 and Robin decided that her company will have a total of 100,000 Sweat Equity Shares then the value of each share will be CAD 5. If Robin feels that Lily will be doing work worth CAD 50,000 and Marshall will be doing work worth CAD 10,000 then Lily and Marshall will be getting 10,000 and 2,000 shares respectively.

B. Valuation for Real Estate Sweat Equity:

For a homeowner, the time and effort he puts into making improvements to his home is the “sweat” here. When he finally sells it for a much higher price than what he paid for, the additional amount received on the sale is sweat equity.
Let’s say, the previous owner renovates the kitchen tiles, adds a new bathtub, and redecorates the lawn. In this case, sweat equity would mean the additional return, provided the new homeowner appreciates the modifications made. In other words, the difference between the value of the home before it underwent changes and the price of it in the market is the sweat equity. If the end result is anything but professional, all that sweat will go in vain.

 

How to create a Sweat Equity Agreement?

Startups should state clear terms before entering an arrangement with sweat equity partners. Clarity about one’s contribution will set realistic expectations. Some important terms considered while designing these agreements are:

Vesting period – In a startup, the vesting period for partners and early-stage employees is decided based on their expertise and extent of commitment to the business. A founder can receive 25% equity as a sign-on bonus with no ‘cliff’ while an employee with 30% equity might have to wait for the ‘cliff’ and further two years before 100% share ownership. Also, clearly define the schedule for stock shares and options.

Type of Equity – The allotment of the type and quantity of shares align with the vesting period decision. These terms and prices will vary in the sweat equity agreement based on the partner’s expertise and value-added to the business.

Performance criteria – It is common for senior talent in a startup to take up multiple roles. It takes a while for startups to reach a stage where specialized hiring is possible. Thus, while designing a sweat equity agreement, it is important to clarify the job expectations from a high-potential resource. Besides the above description, it would be wise to look into performance measures.

Separation Criteria – If not planned well, exiting a startup arrangement can be a tad messy for a co-founder. If one of the founders leaves midway for reasons unforeseen, it does not discount any of their efforts until that time. Hence, a sweat equity agreement should accommodate fair exit plans as well.

 

sweat equity checklist - PLI

Final Word

Sweat equity is determined by the time and labour that goes into creating a business. One contributor injects finance into the venture whereas the other party puts in the long hours. This method has stood the test of time which propels the business moves forward to success. 

For cash-strapped entrepreneurs, sweat equity would be the best bet to go ahead with. Essentially, the aim of it is to make a business more valuable. Once the venture starts making profits, sweat equity can be realized and distributed. 

 

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Professional Leadership Institute (PLI) is an educational website providing professionals from all types of businesses with practical education in human resources and leadership. To keep evolving your leadership toolkit, additional PLI resources below will be useful:

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