noun: value in a property, business, etc., that results from the work that a person does to improve it;
also : the work itself”
Part 2 of Your Partnership Will Fail!
My research for this article solidified the need for a clear and concise presentation on how to utilize a formal sweat equity arrangement to help protect your startup business. I have found that “sweat equity” has more diverse definitions than expected and is utilized as common phrase in many contexts, including:
- Work done to upkeep home or other property
- Work done to improve home or other property
- Money saved by doing work yourself
- Home or other property value increase from doing work yourself
- Deferred compensation
- Labor performed by members of an employee stock ownership plan (ESOP)
- One component added to cash contribution to determine the value of a startup
- Capital contribution cash equivalent given to partners for services delivered and/or work performed
For our purposes, we will focus on that last one. Everyone goes into a partnership with what they believe to be common sense expectations only to later realize that these “expectations” were not so “common” among all business partners. This is most prevalent when it comes to determining the actual ownership value (“equity”) or your non-cash contributions (“sweat”). A formal sweat equity arrangement defined from the beginning of your startup business partnership will pre-diffuse many future struggles you would have otherwise had.
What is “sweat”?
As stated above, “sweat” is the non-cash contributions made to the startup business. This can come in many forms, like:
- Actual labor – work performed over a period of time
- Mental capacity – specific knowledge provided
- Name cachet – value by association
- Services provided – use of utilities at no direct cost
- Intellectual Property – defined methods, approaches or techniques
- Physical donations – provision of tools or space
What is “equity”?
In most arrangements, people are paid in cash for their “sweat”. Within this context, “equity” refers to a dollar value contributed to the business startup in your name (“capital”).
2 steps to protect your business startup from a sweat equity disaster
1 – Clearly build sweat equity into your cap table
Ownership percentage should never be assumed among partners. I know that sounds obvious, but I am amazed at how often these discussions never take place at the formation of a business startup. It is of utmost importance to explicitly define and document everything required of partners and ownership value received for those dollar and sweat contributions. This is most easily achieved through creation of a capitalization table where the cash value of all dollar and sweat contributions are delivered on a defined timeline. Building this spreadsheet will force hard conversations to take place; thankfully, they are taking place during up-front negotiations.
There are many ways to value “sweat”; the important thing is to get that negotiated value clearly documented in your corporate files. Failure to do this will not only lead to a breakdown in your partnership; it will be a stumbling block during due diligence with future Angel and VC investors.
2 – Record sweat equity on your balance sheet
All cash equity is recorded on a company’s balance sheet. This is important for valuation and tax purposes. At some point, the predetermined cash value of your sweat equity must also be recorded. Apart from this important step, this equity doesn’t legally exist. Partners do have some flexibility in the timing of this balance sheet entry and should consult their legal and accounting firms for what’s best from a taxation standpoint.
Following these basic steps will not only serve to protect you when your partnership encounters strife; they will make your business startup more attractive to Angel and VC investors during due diligence.
Your Partnership Will Fail! continued…