Sweat Equity

Sweat Equity: You have heard the term ‘sweat equity’. It is the opposite of ‘financial equity’. Many entrepreneurs pride themselves on their sweat equity. Frequently they overvalue sweat equity. When it comes to the equity valuation of a company, ‘sweat’ is almost always calculated differently by founders than anyone else, like lenders or investors. Sweat equity will really only have value attached to it pre-money, or before any serious money has been invested.

It is interesting that if an investor agrees to a company’s valuation, it might include the amount that this outsider considers the founder’s sweat equity is worth

Equity Dilution

For example, if an entrepreneur has invested $100,000 of real money, sells a stake to an angel investor for $100,000. Then the angel values the business at $500,000, as investor he is buying a 20% stake. The founder’s stake is then diluted from 100% to 80%, and his sweat equity has been valued at $300,000, or $400,000, less the $100,000 that he has actually spent in cash.

This is very simplistic calculation and every case will be different. Had there been no outside investor, then the founder might have dreamed that his sweat equity in the company was worth three times earnings or some other multiple, but in reality there will be a number of factors that go into making the valuation, somewhat depending upon who is doing the valuation—the owner or someone outside the business.

Factors of a Valuation

The factors that will be considered in any valuation are likely to include:

• Reasons: The reasons why the valuation is needed itself will be a dominant component. If the product/innovation is something that the investor/buyer wants, this will be a factor beyond financial performance. On the other hand, if the motivation is to leverage another position (say a buyer’s product, or an investor’s market position), then this will influence the price.
• Management: the quality of founder/owners and their management team will be a fundamental factor in valuing a young business, without much of a track record. The skills, experience and abilities of the people are probably the most important ‘value’ of the business, but it’s anyone’s guess about the right price to strike. For sure, the sellers will expect more for the value of the sweat equity, and the buyers, will offer less for the value of the sweat equity.
• Earn-outs: notwithstanding their sweat equity, owners may often be required to do an ‘earn out’, if they intend leaving some time after a sale. One of my companies was on the receiving end of an offer that included an earn-out. The potential buyer insisted on deciding on new senior management recruitment. This meant that I would no longer be able to steer the direction of the company, and thus influence the performance. So we turned down the offer.
• Financial analytics: financial track record. Not just historical margins and profits, but also sales progress and earnings growth, as well as market penetration. Cash flow, both past, current and forecast, will be an indicator of the strength of the business. However, cash flow forecasts are notoriously unreliable, especially in young companies and an investor/buyer will apply a discounted cash flow analysis to them.
• Future earnings: nonetheless, a typical way of valuing quoted companies is based on the forecast of future earnings and applying a multiplier. On the stock market it is referred to the P/E ratio (Price/Earnings) that measures current share price relative to its per-share earnings. In unquoted companies, such a calculation could only be a contrivance, because there is no wider market for shares.
• Sector profile: the normal financial records, especially P&L and balance sheet are obviously a factor, but the raw numbers are not what matters. What they imply matters more, especially given the nature of the business. In oil & gas, EBITDA can be as high as 50%, whereas in retail it can be as low as 5%. Other industry specific factors can be make or break in attaining high valuations, if your business is way off the norm for the sector.
• Competition: the competitive position of the company and its new product development will be critical factors. What looks like a great company may have reached its zenith and its life cycle may be on a downward trend. There may be a disruptive innovation in the wings. Competitive sales channels may be weaker or stronger and thus offer opportunity or threat.
• Customer base: whether the company has a good spread of customers, or whether it relies on a small number of individual clients who might put the company at risk if one or more left—the ‘all your eggs in one basket’ factor. The kind of relationship that a company has with its customers is a critical ingredient, too. What is the proportion of repeat sales and the age profile of the customer relationships will be things that will impact an evaluation of the business.
• Assets: material/physical assets will figure large. When I began to seek the sale of what we called a ‘vaporware’ company, full of expertise and clients, but few tangible assets, I was put under pressure to buy assets, particularly real estate. The bank had been pressuring me for years, even though we had no need—renting premises was fine. In any event, the means of valuing assets includes acquisition cost, replacement cost, or accumulated depreciation value. Maybe those assets could be more (or less) valuable in different ownership.

Perspectives of Seller, Buyer and the IRS Are Different

Some of the factors impacting the valuation may be impacted by the sweat efforts of founding shareholders (and the creation of what they see as sweat equity). On the other hand, many sweat efforts that the owners may consider worthy of value, will be downplayed by buyers wanting to minimize the cost of acquisition or push down the value of your equity and increase their own.

Thus it can be seen that sweat equity is just one factor in valuing a young venture. In short, the value of the sweat equity is in the eye of the beholder. “I have sweated my guts out and foregone a salary for two years…” says the seller. “That was your choice…” says the buyer!

On the other hand if you are generously rewarded for your sweat equity at the time of selling, beware! The tax man will treat the gain as income. You must seek the advice of a tax expert if you sell out in this way. On the other hand you should be paid a salary like your other employees, and avoid working for nothing, even if you take out less than the market rate.

You may consider other options such as selling the business to employees through an ESOP or Co-op, but the tax implications still need careful attention. I am very much an advocate of bootstrap finance, but in the same way, you should be aware of the tax implications of bootstrapping through what you consider is the sweat equity of underpaying yourself or co-founders.