What happens when you start a company and you need to determine how to value your initial contributions? The idea of Sweat Equity is that there are two different types of contributions when you start a business. The first is a monetary contribution tradition which is looked at as putting money into a company, like an investor's investment. The second type of contribution is non-monetary, and that's the idea of Sweat Equity for business founders.
What is Sweat Equity?
When people meet with me, the founders often have heard of Sweat Equity, but they're not sure exactly how it works. Sweat Equity is when founders who are putting in time and effort into their business want to measure their contributions by putting a value on it. Often, people who are starting a business don't have a ton of money to invest in the business. Instead, they can use this non-monetary form of contribution, Sweat Equity, to help them recognize their contributions when the company is getting off the ground. If you're just starting a company on your own, you don't have any workers, you don't have anybody else involved, you may not need to use and award Sweat Equity. You can just start your company and down the road, if you take on investors, make sure your initial contributions are being recognized. However, if you have partners, it's important that each partner feels that their contributions are recognized by the business.
If you have one person putting in $10,000, another putting in $5,000, and a third partner is going to be doing a lot of work, maybe all the technology work, the question is how are we going to value everybody's time and efforts contributing to this company? One way we can do it is by Sweat Equity. Even though the third partner was not putting in any money, she can get recognized for all the hard work she's doing to help the company get off the ground with it.
Another way you can try to recognize contributions is through a straight award of stock options to those who were there when you started your company.
How Do We Calculate It?
Once you've decided to use Sweat Equity, the next logical question is "How are we going to calculate the Sweat Equity?" One place to start is to look at the time spent by each person. My opinion is that time is actually worth more than money. All of that time and hard work you're putting into the company should be measured when it comes to the value of the business.
We want to look at how much time each person spends and maybe create a ratio between somebody who spent 45 hours (#1) somebody who spent 30 hours (#2) and somebody who spent 25 hours (#3). For example, just using the time spent by each person, for those 100 hours of work, you'd divide up the interests:
We can also choose to use stock options as a way to recognize the different levels of timing between the partners and award stock based on those same ratios. It's a smart way to make up for a lack of cash when you start doing business. If not everybody has a bunch of money, but they have real technical expertise, this is a great way to reward them for helping you start your business. If you're in the tech sector, and for example, you're creating an app, this can be a great way for you to work with a programmer. Let's say you have a great idea and they are going to be the one to do the coding for it but they're not really putting money into the app, but what they're putting in is probably more valuable than anything in their bank account. They're creating that code or helping you get into the App Store. These are the kind of situations where you use Sweat Equity or you want to use the stock option to reward the hard work down the road.
Valuing Sweat Equity Down the Road
Let's say you've started your company and we've divided up equity with Sweat Equity and maybe some regular monetary equity. If you bring on investors down the road and you're putting your valuation on the company, those Sweat Equity awards, whether it's stock options, whether it's a percentage ownership in the company, are worth as much as cash investment. So if the investors value the company at a million dollars, you have 25% as Sweat Equity, you now have value of $250,000 in that business, you probably didn't put in that kind of money from your bank account, but that's what it's worth.
So if you're starting a business and you don't have a ton of cash on hand, this is a good way for you to start by distributing ownership interests. It's important to remember that your Sweat Equity needs to be documented in some way. You don't want to just have a handshake between three partners and just assume we're all on the same page or don't worry about it down the road.
If you're ready to get started with Sweat Equity in your business, or if you have more questions and you'd like to learn more, let's set up a Legal Strategy Session to discuss your business and the next best steps you can take.