Can you put a value on sweat equity? How is sweat equity determined? This article will also provide examples and analogies to better explain sweat equity, its elements, and value.
What is Sweat Equity?
Sweat equity is the time and effort that shareholders and executives put into a company. While sweat equity isn't determined by the money owners invest into their businesses, sweat equity does have value. The knowledge, time, and effort that a group or individual puts into a business represents sweat equity.
Sweat Equity Compensation
In some cases, businesses can lower their start-up costs by using sweat equity. Businesses can offer business service providers shares of their business stock instead of money. This is more commonly known as sweat equity compensation. This benefits those who provide services to the business because it allows them to obtain shares into the business. However, the majority of service providers prefer upfront money, so financing a business with sweat equity compensation can be difficult.
Understanding Sweat Equity
When describing sweat equity, it is easiest to do so using real estate as an example. The value of a home can be increased by remodeling the kitchen, adding a deck to the back of the house or making minor home repairs. When a home owner makes these repairs and additions themselves, with their own sweat and labor, they increase the value of their home by applying their own efforts. This is how sweat equity works for all businesses. By doing the work without hiring outside help, sweat equity builds.
Determining the Value of Sweat Equity Using Market Value
To determine the value of sweat equity, one must put a value on their time. However, they must keep in mind that the market value isn't necessarily equal in value to the sweat equity invested by those in the business. For example, the owner of a restaurant may have invested $50,000.00 worth of their time drawing up the restaurant's business plan and their partner may have invested an additional $25,000.00 of their time creating the restaurant's design plan. However, this does not mean that the market value of this restaurant is $75,000.00. In many cases, it could be worth a lot more than that.
Determining the Value of Sweat Equity Using Foregone Wages
Using the above restaurant example, business partners estimated $25,000.00 based on what they could have earned at a full-time job creating design plans. Foregone wages are the most common way that business owners determine sweat equity. Business partners can also argue that their time spent creating the design plan was worth $100,000.00 because that's what a design firm would charge to design the restaurant. By using foregone wages to determine sweat equity, this argument will be avoided.
Most business finance experts say putting a value on sweat equity can be difficult as a bargaining tool, especially when it comes to funding your business. On the other hand, sweat equity does have value and can be a negotiation tool if business owners can provide hard and true examples of the sweat equity achieved at the onset of their business operations.