You might have heard of the term “sweat equity” or not. While it sounds like a new age term associated with startups, the concept has been around for a while.
Sweat equity is a term that is used in the business world to describe the idea that you should get some ownership in the company you are working for. Sweat equity is what makes employees and other stakeholders apart from the founders feel as though they are a part of the organization and are invested in its success. The more time you put into your business, the more equity you will have in it. This will give you a personal stake in seeing it grow, and make you more committed to your work. If you are considering starting a small business, sweat equity may be one of the best things you can do to make sure it succeeds.
In practice, business owners and founders rarely have a choice but to invest their “sweat,” especially in the early years of a company when financial and technical resources are limited. This usually means that they will go through a period where they will not be compensated for all their efforts in building a business, but this is considered normal.
Employees, advisors, and other professionals who may work with the founders in their business dealings face a vastly distinct set of circumstances. They expect to be paid fully and fairly for the work they put in to build a business, regardless of whether the company has the resources. As a result, businesses tend to miss the experience and expertise of having top-level experts chart a clear strategic direction. According to a recent study, not having access to quality professional support and advice is listed as one of the major reasons small businesses and startups fold up in their early years.
What exactly is Sweat Equity?
Sweat equity is a non-monetary investment that individuals receive in exchange for their contributions to a company. Sweat equity is frequently offered in exchange for work done for free – or at a lower market rate – thus the term “sweat.” Sweat equity can also be traded for intellectual property rights, “know-how,” reputational association, introductions to key contacts, or the provision of materials, tools, and space. Sweat equity is an ownership stake in a startup that is used to compensate those who make non-monetary contributions to the business. If a new company does not have sufficient cash assets to pay partners, employees, or other experts needed to get their business off the ground, they may issue equity in the company in lieu of some or all monetary compensation. This equity is intended to compensate them for their hard work (or “sweat”).
According to Wikipedia, sweat equity refers to a party’s contribution to a project in the form of effort, as opposed to financial equity, which is a capital contribution. Some partners in a partnership may contribute only capital to the firm, while others may contribute only sweat equity. Similarly, in a startup company formed as a corporation, employees may receive stock or stock options, thereby becoming part-owners of the firm, in exchange for accepting salaries that may be lower than their respective market values.
The Advantages of Sweat Equity
Sweat equity is strongly recommended for business owners and startup founders for the following three reasons:
1. Saves money
Many new businesses are short on financial resources and need to keep costs exceptionally low to survive. Offering sweat equity as compensation can reduce costs while the business grows and becomes more profitable. This is useful because businesses are rarely flush with cash, so anything that avoids cash burn while still getting things done is bound to be appealing. If significant expenses can be paid for using shares, then it will be considered a contribution to the business without cash having to leave the business.
2. Attracts talent and skills
By offering equity, a business can attract valuable employees and professionals that it might not have been able to afford. This can be particularly useful for a fledgling business in dire need of a set of skills or connections. Offering sweat equity can offer startups the chance to attract a co-founder or key employee of the calibre required to grow the business. The good news is that these professionals do not need to work full-time in the business, which saves the company money.
3. Creates incentive
Those who are compensated with sweat equity may be more motivated to do their best work to help the company succeed, thereby increasing the value of their stake in the company. Employees with sweat equity work to grow the business, increasing the value of their shares as the business grows in scale and success, creating a solution that benefits everyone.
Cons of Using Sweat Equity
To make an informed decision, business owners must consider the potential risks of issuing sweat equity, which can include the following:
1. Sweat equity can be difficult to value.
Sweat equity will be tough to quantify. You will need to determine what the sweat equity is worth, and it might not be easy.
It depends on the company and the type of work done, but deciding how much stock to give away for work done can be difficult.
2. Can cause conflict
Because there can be uncertainty surrounding sweat equity valuation, there is a possibility for friction to occur. This often arises when the sweat equity holder feels that the value of their labour is higher than the value of the shares granted. It also works the other way; the issuer may feel that the sweat equity holder is not delivering up to the value of the shares given.
3. Prone to fluctuation
In a growing corporation, the value of a share is subject to significant fluctuations. While this is applicable to any company, sweat equity has the potential to be worthless or to increase in value to the point where the issuer may end up paying significantly more than they expected to pay.
A simple example: A startup (pre-funding) may require a Chief Finance Officer with extensive industry experience and a salary of at least N15 million per year, but it lacks the capital to attract the quality required to differentiate the business from the competition. By offering equity in the company as compensation, the business has a better chance of
(1) saving costs by not breaking the bank
(2) Hire someone of high enough quality despite not really having the money and,
(3) creating a path for the hire to grow the business and generate the resources to pay for his own services. The example can be applied to any critical role in the business.
There are numerous reasons why you should consider sweat Equity as your primary source of financing for your small business. The key is to find the right partner who understands your unique needs and can provide you with the guidance and support needed to make your investment a success.
In summary, business owners have the opportunity not to “sweat” alone by considering offering sweat equity to others who will help grow their businesses.
At myCFOng, we have accounting and finance professionals as well as access to other professionals who are willing to work with your small businesses and startups for sweat equity considerations. Need a partner? Contact us right away.