Do you want to take a business partner or form an LLC and you need to write an agreement? If YES, here is a guide on how to properly calculate sweat equity.
Sweat Equity simply means sharing ownership of your start-up with your team, including employees, consultants, advisors, board members, etc. For a lot of companies, almost everyone who works in the fields to make the business successful deserves a piece of the action, if you will.
It is as simple as that. Ultimately, Sweat Equity is a tool (a business asset, actually) that emerging companies use to recruit, retain, and incentivize the best team members. These companies do this, in the context of their compensation package, by giving them a share in the business: a stake that might ultimately be worth a good chunk of change.
Importance of Sweat Equity
Sweat equity compensates for the shortage of cash. Most founders of start-up companies in the united states are often less privileged by the lack of funds to finance their activities. However, they dedicate their time to grow the company through effort and toil, which are rewarded back when the company becomes profitable.
Sweat equity can also be considered as valuable as cash equity. Sometimes, large investors invest their money in small but growing companies with the potential to become large companies in the future. Note that employees who take a pay cut at the early stages are rewarded through stock options and ownership percentages that place them on the same page as cash equity investors.
In real estate, some owners make DIY improvements on old houses and sell them at a higher market value than their value before the renovations. The key benefit of sweat equity is that it lets companies raise funds without raising debt levels. New companies are always met with challenges when raising capital and obtaining too much debt may affect the business negatively.
Sweat equity offers these businesses a platform to get “free money” by selling a portion of the company to investors. A proper accounting of that sweat equity is necessary to ensure that owners and investors alike get a clear understanding of the financial health of the company.
How to Calculate Your Sweat Equity
Since sweat equity does not represent financial commitment in a business, one must value the amount of time spent on an activity or in developing the business. However, if the company measures its valuation in terms of share of stock, the value of each share must be determined before deciding the number of shares to allocate to the person performing the sweat equity. Without further ado, here are few ways to calculate your company’s sweat equity:
- Value of the Business
To effectively calculate any sweat equity, you will have to first determine the value of the business. Since you are planning to compensate somebody with “part” of the business, it is necessary you first understand what your business is worth.
You need to know how big or small a part of the business the person should receive in exchange for services rendered. Note that one way to calculate the value of a new business is by simply looking at the start-up capital that’s been put into it. For instance, if you put $500,000 into a start-up, then the value of the business is $500,000.
Another method is the use of comparable to ascertain the value of your company. Check out how much companies like yours are selling, it should be worth about as much as others in the same space and region. You can also consider using your company’s discounted cash flow to determine its value.
If your business is already earning revenue, you can leverage a discounted cash flow model to calculate its value. That’s where you value your business based on future cash flows. Know the worth of your business by using a multiple of current cash flows.
For instance, if your business has a cash flow of $100,000 per year, simply multiply it with a valuation figure to determine the value. You can choose to multiply it by two or as much as five, depending on the nature of your business and the growth potential. Howbeit, still consider checking how other similar businesses are being valued to determine the multiplier that’s best for your business.
- Value of Each Share of Stock
For a corporation, you have to ascertain the value of each share of stock so that you can effectively pay the person performing the sweat equity the appropriate number of shares. For instance, if your company is worth $1,000,000 and it has issued 100,000 shares of stock, then each share is worth $10.
While for partnerships and LLCs, you will have to use percentages instead of shares of stock. For instance, you’ll “pay” the person performing the sweat equity 10% of the company instead of 10,000 shares of stock.
- Value of the Sweat Equity Performed
You can leverage the “foregone alternative” method to ascertain the value of the equity. In simple terms, what could the person have earned if he or she had done the exact same work for another company? That’s the value of the sweat equity earned.
How much did the sweat equity contribute to the value of the business? There may be a scenario where the sweat equity contributed much more in value to the business than the actual cost of labour. For instance, if you paint a house, you could earn $2,000 for the work.
This would be the market value of your work. Nonetheless, you might add $3,000 to the value of the house by painting it. This represents the value added to the house based on the addition of your labour. Both of these numbers are estimates, so actual amount of sweat equity may be in the range between the two.
How to Write Your Sweat Equity Agreement
A lot of businesses in the United States are worth more than the sum of their parts. Sweat equity represents the value of the hard work you put into your business. In recent times, it has been the most common way entrepreneurs and start-ups leverage to fund their businesses. Nonetheless, below are detailed steps to write your Sweat Equity Agreement efficiently:
- Value the Business
The first step when writing your sweat equity is to calculate the total value for the business based on the capital or assets invested in the business. For instance, if investors have provided $400,000 in capital and equipment worth $200,000, the business’s total value would be $600,000. For businesses already operating, you could also base the value of the business on the business’s expected income over the next three to five years.
- Know your Equity Limits
Secondly, you will have to explicitly determine the total amount of equity (or ownership) that may be earned via the structured sweat equity position. Note that some two-person partnerships may allow up to 50 percent of the company to be earned via sweat equity while businesses with multiple investors may limit the amount of sweat equity that can be earned to an amount equal to the other investors’ stake in the business.
- Create a Fair Labour Rate
You will also have to set the rate at which the labour invested will accrue toward equity in the business. In the United States and for a lot of businesses, this means simply ascertaining the sweat equity partner’s salary or hourly pay rate and then applying that rate to their ownership stake as hours are worked. For instance, a sweat equity employee who worked 40 hours at a rate of $5 per hour would have earned $200 in equity capital in the business.
- Choose a Vesting Period
Take your time to decide if your sweat equity agreement will have a “vesting” period, i.e., a time that must transpire before the employee’s sweat equity is converted to ownership equity. For instance, the business may have a sweat equity partner whose equity is only converted, or “vests,” after one year. Note that vesting provisions help to prevent workers from leaving a business before their sweat equity has been fully converted into ownership equity.
- Write the Agreement
Be detailed and careful when writing your Sweat agreement and make sure it includes all of the provisions above. Carefully detail how much equity will be accredited to the sweat equity partner for each hour (or week or month) of labour provided.
Note any minimum or maximum equity earning limits you’ve decided upon, along with any vesting period you may have decided to impose on the position. Also specify the exact time the sweat equity will be converted to ownership equity (be it monthly, semi-annually, annually or over any other period of time) since the ownership stake may determine voting rights, profit sharing and other legalities of business ownership.
- Sign and Notarize the Agreement
It is advisable you take two (or more) copies of the contract to a bank or other institution with a notary public and have all interested parties sign each copy of the contract, allowing the notary to witness each signature. Note that each participant will be mandated to provide photo ID prior to signing the documents. After signing, both parties should retain their own copies of the contract for future reference.
It is important to state that once you pay a person in stock for work performed, you can’t take the shares back if the person quits working or doesn’t do a good job. Figuratively, once you give somebody 5,000 shares, you can’t take them back.
Note that this why some people pay sweat equity partners an effective hourly rate in shares. The more the person works, the more equity he or she earns. Additionally, payment for sweat equity in stock shares is a taxable transaction for corporations.