What Is Sweat Equity?
Sweat equity is the non-monetary investment that owners or employees contribute to a business venture. Startups and entrepreneurs often use this form of capital to fund their businesses by compensating their employees with stock rather than cash, which also helps to align risk and rewards. In real estate, it refers to value-enhancing improvements made by homeowners to their properties.
Understanding How Sweat Equity Works
Sweat equity is often used to refer to the effort and toil a company’s owners and employees contribute to a project or enterprise—and the value it creates. In cash-strapped startups, owners and employees typically accept salaries that are below their market values in return for a stake in the company, which they hope to profit from when the business is eventually sold.
For example, an entrepreneur who invested $100,000 in their start-up sells a 25% stake to an angel investor for $500,000, which gives the business a valuation of $2 million (i.e., $500,000 / 0.25). Their sweat equity is the increase in the value of the initial investment, from $100,000 to $1.5 million, or $1.4 million.
[Important: Sweat equity—which is a form of non-cash capital—is also known as equity compensation and can take the form of stock options, restricted stock units (RSUs) and performance shares.]
Shares may be issued at a discount to directors and employees to retain talent, while performance shares are awarded if certain specified measures are met, such as an earnings per share (EPS) target, return on equity (ROE) or the total return of the company's stock in relation to an index. Typically, performance periods are over a multiyear time horizon.
For example, private equity (PE) firms may reserve a significant minority stake in acquired companies to incentivize management and align their interests with the PE investors.
Sweat Equity in Real Estate and Other Property
The term sweat equity originally referred to the value-enhancing improvements generated from the sweat of one's brow. And this is still what is meant by sweat equity in real estate, or automobile and boat restoration projects. Sweat equity can be used to lower the cost of home ownership, as Habitat for Humanity does.
Habitat for Humanity homeowners have to contribute at least 300 hours of labor, building their own and their neighbors' homes, before taking up residency. Besides increasing home affordability, the program also gives homeowners a sense of accomplishment and pride in their community. Landlords are sometimes willing to trade equity in a property, in return for maintenance work.
Real estate investors who flip houses for profit can also use sweat equity to their advantage by doing repairs and renovations on properties before putting them on the market. Paying carpenters, painters, and contractors can get extremely pricey, so a do-it-yourself renovation using sweat equity can be profitable when it comes time to sell.
- Sweat equity is the unpaid labor employees and cash-strapped entrepreneurs put into a project, whether it be a start-up venture or renovating a property.
- Sweat equity is also known as equity compensation and can take the form of stock options, restricted stock units (RSUs), and performance shares.
- In cash-strapped startups, owners and employees typically accept salaries that are below their market values in return for a stake in the company.