It comes as a surprise to a lot of people that not all of the equity that a company builds is cash-based. There are some intangible types of equity that help businesses build themselves over a stretch of time. One such equity is sweat equity. If you wanted to learn everything there is to know about this type of equity, you have landed on the right article.
What is sweat equity?
Sweat equity shares are the shares that are issued to an individual or a company's contribution to a particular project. This equity is not monetary based, and hence the name denotes something that an individual invests! Click To Tweet Generally, this type of equity comes in the form of physical labour, mental efforts and time dedicated.
This type of equity is usually found in industries like real estate, construction, industrial farming, as well as in the startups and corporate world.
Importance of sweat equity
Sweat equity compensates whenever there is a shortage of cash. It is seen that often, the founders of start-ups face concrete challenges due to lack of funds to finance their ideas. However, they devote their time and energy to keep the company going. These efforts are rewarded when a company becomes profitable.
Also, it must be noted that sweat equity is as valuable as cash equity. We often see that some renowned investors invest money in small but growing companies. They see the potential in them to become large in the future. And this potential is what makes up sweat equity!
The 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.
Lastly, as mentioned, this equity simplifies the process of raising funds for companies without increasing their debt levels. Sweat equity provides them with a platform to get “free money” by selling a portion of the company to investors.
Consider this example to understand better: A founder may value the time spent in growing the company at $100,000 but sells 25% of the company to an investor at $1,000,000. The valuation puts the company at $4,000,000, giving the founder $3,000,000 in free money.
How to calculate sweat equity?
After knowing some of the basics of, the next important point is how to calculate it. To understand this, assume that you invested $1 million in your business, and a friend, an angel investor wants to invest another $5,00,000 for a 20 percent total equity stake. If you sold your friend a percentage that is equal to just your invested capital ($1 million), 50 percent of it would be equal to $5,00,000, but in this case, they get only 20 percent of the total equity stake. This means you have created additional value in your company.
Now, to calculate the exact amount of your equity, divide the amount of your investor’s money by the percentage of equity it represents. This means, divide $5,00,000 by 20 percent i.e $2.5 million. Now, out of this $2.5 million, $1 million is your invested money, $5,00,000 is your friend’s investment, and the remaining $1 million becomes your sweat equity!
To conclude, sweat equity plays a vital role in a business’s lifespan, especially when an acquisition or funding takes place. If you are a business owner, make sure to keep track of your sweat equity while you focus on business growth!