For a cash-poor entrepreneur, building equity in a company may be accomplished by the contribution of sweat equity. Defined as the equity generated from ‘the sweat of the brow’, sweat equity can be defined by the value (equity) added to a company through work. Typically unable to afford to pay into the capital of a firm, the entrepreneur contributes ‘sweat’ through working, and accumulates a financial interest in the firm.
Similar to the idea of a homeowner who makes improvements in a house, sweat equity can be seen in improvements to a company, the development of new products or services, or the furthering of a company. These non-cash investments in a company are repaid by the distribution of stock or other forms of equity. Sweat equity is an important tool for the beginning company wishing to expand but without the budget to do so. Utilizing skills and know-how that people may have is an excellent method of advancing the company.
Disadvantages of Sweat Equity
Sweat equity can be a detriment, however, when there is a disparity between the expected valuation of the work by the worker, and the equity paid by the company. Often, individuals value their sweat equity at a much higher rate than the market value, while companies tend to minimize the value of sweat equity. An agreement should be reached before commencing any sweat equity arrangements, thereby eliminating the possibility of disagreement.
The value of sweat equity can change over time, as the overall long term effect of the value may be affected by the commitment of the people contributing the sweat equity as well as the length of their commitment. A careful evaluation of the value of sweat equity, as well as the potential for future valuations must be taken into account at every stage of company start-ups.