Sweat equity refers to the non-monetary investment made by individuals, typically involving labour, time, or effort, into a project or business to increase its value. It is commonly used in startups, home renovations, or partnerships where contributors receive ownership or shares in exchange for their work.
It is very popular amongst young, cash-poor businesses looking to compensate and reward early-stage employees and co-founders. Often the decision on compensation comes down to the CEO, but on the basis of investor suggestions.
However, there is no consistent way to calculate this figure as it relies on individual circumstances. Here though, we provide some basic factors to consider when calculating it. Likewise, we will discuss how it affects company valuations.
Calculating sweat equity
The most common basis for sweat equity valuation will be on forgone wages. A forgone wage refers to the wages the employee missed out on by working for the company for free or with little compensation. So for example, a designer who has spent type designing your prototype for free may argue that they forewent $30,000 in wages from another job.
However, they may also argue to take into account avoided costs. Continuing with our example, let’s say the cost of hiring a full-time designer outright would have been $100,000. The designer seeking sweat equity may then argue they deserve that in compensation as the company saved that money. Likewise, they may also argue that they took on a lot of risk by performing the task for free, and should be rewarded fairly.
However, at the end of the day, it is on the CEO to make these decisions regardless of what these employees may argue. While investors may have a lot to say about what they think is fair, likely as the CEO you will have seen this person’s commitment to the business. Consider their passion for the project and how you feel it is fair to compensate them, whilst maintaining investor interests. Likewise, be careful not to overcompensate and upset the other shareholders.
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How sweat equity relates to company value
The key thing to remember when providing compensation via sweat equity is to not mix up time investment with market value. Just because the designer has invested $30,000, doesn’t mean that your company has increased by $30,000 in value. The real market value may be much higher.
Take the angel investor scenario for example. You have calculated that the designer has contributed their $30,000 worth of time and you have committed $70,000. If an angel investor were to come along and provide $500,000 for a 10% stake in the company, your company’s value will be $5,000,000.
This doesn’t then mean that the designer’s sweat equity value should be diluted to 0.6% (30,000 / 5,000,000). Rather, it should be adjusted to represent their previous commitment to the company. For example, a 30% stake (30,000 / (30,000 + 70,000)). Though, this will depend on what you and the investors feel comfortable with.
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Final thoughts
Ultimately, sweat equity is a great way to reward early adopters and loyalty amongst your employees and co-founders. However, there still remains the risk of overcompensating. While it may feel good to reward loyalty, overpaying may set a poor precedent and annoy investors. It is often advised that paying a slight premium on foregone wages is a good way to ensure appropriate compensation without over-extending. Nonetheless, at the end of the day, it is the CEO’s decision on these schemes and it is important to think these over prior to any confirmation.
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