Starting a new business is often a point in one’s life when people decide to take a leap of faith. This can often mean waving bye bye to years of savings, or even taking out loans to cover costs if a new venture. Something that’s often overlook however, is the personal investment that new business owners make. The blood, sweat and tears that go into building something new.

Thankfully, there is recognition for the non-monetary investment that new business owners contribute to their new endeavours. It is becoming increasingly common to see joint ventures whereby one enters into an investment with capital and the other with sweat equity.

Blood, sweat and tears

Sweat equity is contributed by way of time and hard work. With one party investing funds into a business, and another investing effort and work of the same value, the business can progress and its a tested formula for successful entrepreneurship. The concept of sweat equity is a term that is broadly defined as the increase in value in something created directly as a result of hard work. And it’s a preferred mode for entrepreneurs who don’t have the initial funds for their ventures. It’s literally the sweat off your brow, quantified into a price tag.

Sweat equity works to build up the worth of a business to be more valuable than the original investments. This is an important part of business ownership. Of course, any business owner/investor wants to see their project translate into financial success, and this is where sweat equity takes the stage.

DOCUMENT: Partership Agreement

How it works

Given that sweat equity does not represent financial commitment in a business, one must value the amount of time spent on the development of the business. Let’s take the development of a fashion brand as an example. We may have a business graduate and a leading fashion designer discussing a new business idea to create a sustainable fashion business that combats fast fashion. The business graduate has capital of $100,000 to invest into their new business. But the fashion designer has no capital investment funds to contribute to their budding business. Let’s face it, without one another the business will hit a dead wall and sustainable is the last thing it will end up becoming.

In scenarios like these, the partners can enter into a Sweat Equity Agreement, whereby the work and expertise of the fashion designer will be recognised as an investment of time and work. The business graduate may be able to sit back, control the finances, and watch their partner burn the midnight oil whilst the money rolls in. At the end of their first financial year, it wouldn’t be right that the partner who made the capital investment reaps all of the rewards, now would it? Absolutely not. This is where the sweat equity agreement comes to fruition. By recognising the fashion designers work with a reward equal to the capital investment made.

Determining the value of sweat equity

Before you can determine the value of any sweat equity, you’ll first need to determine the value of the business. That’s because you’ll effectively be compensating somebody with “part” of the business. You need to know how big or small, a part of the business the person should receive in exchange for services rendered. If your business is a corporation, you’ll need to know the value of each share of stock so that you can properly pay the person performing the sweat equity the appropriate number of shares.

For example, if your company is worth $500,000 and it has issued 100,000 shares of stock, then each share is worth $5.

You’ll want to pay a fair market value for the type of work performed. In this case, you’ll do that with a piece of your company instead of cash. Use the “foregone alternative” method to determine the value of the equity. In other words, 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? It may be the case that the sweat equity contributed much more in value to the business than the actual cost of labour. For example, if you paint a house, you could earn $2,000 for the work. This would be the market value of your work.

Once you’ve determined the value of your company and the value of the work performed, pay the person who performed the sweat equity. For example, if you value the work performed at $50,000 and your share price is $5, then pay the person who performed the work 10,000 shares of stock.

Alternatively

Keep in mind that once you pay a person in stock for work performed, you can’t take the shares back if the person stops working or doesn’t do a good job. In other words, once you give somebody 10,000 shares, you can’t take them back. That’s 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.

Notes to remember

Regardless of the terms of a Sweat Equity Partnership Agreement, you always need to make sure you have a written Sweat Equity Agreement in writing to make sure your terms are protected with your sweat equity partners.

Payment for sweat equity in stock shares is a taxable transaction for corporations.

Terri Schofield is a first year LLM with LPC student at BPP, Manchester. Alongside completing her post graduate studies, Terri works full time at DWF Law as an Employment Law Legal Adviser. Terri also sits as the UK Chair of DWF OutFront, their LGBT+ Network, where she is proactive in increasing visibility and sourcing opportunities for DWF’s LGBT+ employees.