Sweat Equity

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DEFINITION of 'Sweat Equity'

Contribution to a project or enterprise in the form of effort and toil. Sweat equity is the ownership interest, or increase in value, that is created as a direct result of hard work by the owner(s). It is the preferred mode of building equity for cash-strapped entrepreneurs in their start-up ventures, since they may be unable to contribute much financial capital to their enterprise. In the context of real estate, sweat equity refers to value-enhancing improvements made by homeowners themselves to their properties. The term is probably derived from the fact that such equity is considered to be generated from the "sweat of one's brow."

BREAKING DOWN 'Sweat Equity'

For example, consider an entrepreneur who has invested $100,000 in her start-up. After a year of developing the business and getting it off the ground, she sells a 25% stake to an angel investor for $500,000. This gives the business a valuation of $2 million (i.e. $500,000/0.25), of which the entrepreneur's share is $1.5 million. Subtracting her initial investment of $100,000, the sweat equity she has built up is $1.4 million.

Likewise, the work an auto enthusiast puts into rebuilding the engine on his 1968 Mustang to increase its value would be considered sweat equity, as would the work done by a homeowner to install a new deck.

Valuation of sweat equity can become a contentious issue when there are multiple owners in an enterprise, especially when they are performing different functions. To avoid disputes and complications at a later stage, it may be advisable to arrive at an understanding of how sweat equity will be valued at the outset or initial stage itself.

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