What Is Sweat Equity?
The term sweat equity refers to a person or company's contribution toward a business venture or other project. Sweat equity is generally not monetary and, in most cases, comes in the form of physical labor, mental effort, and time. Sweat equity is commonly found in real estate and the construction industry, as well as in the corporate world—especially for startups.
- Sweat equity is the unpaid labor employees and cash-strapped entrepreneurs put into a project.
- Homeowners and real estate investors can use sweat equity to do repairs and maintenance on their own rather than pay for traditional labor.
- In startups, owners and employees typically accept salaries that are below their market values in return for a stake in the company.
- Working for sweat equity comes with more risk than a conventional salary, but higher upsides if the company succeeds.
- In rent-to-own situations, some landlords may allow renters to gain equity by performing repairs or maintenance that would otherwise be the responsibility of the landlord.
How Sweat Equity Works
Sweat equity originally referred to the value-enhancing improvements generated from the sweat of one's brow. So when people say they use sweat equity, they mean their physical labor, mental capacity, and time to boost the value of a specific project or venture.
The term is commonly used in the real estate and construction industries. Sweat equity can be used by homeowners to lower the cost of homeownership. 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 also an important part of the corporate world, creating value from the effort and toil contributed by a company’s owners and employees. 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.
Cash-strapped businesses may provide compensation for an employee's sweat equity in another form such as shares in the company.
In many cases, people have to use sweat equity—their time and effort—to contribute to the success of a company. That's because there's very little capital to pay salaries. Unless you're the owner, everyone expects to be paid for their time and energy. After all, no one wants to work for free.
While a company may not yet have enough capital to pay its employees, it can provide compensation in other forms. For instance, startups may provide key employees with an equity stake in the company. Other, more established companies may provide their employees with shares in the corporation as a reward for their sweat equity.
Example of Sweat Equity
Habitat for Humanity homeowners must contribute at least 300 hours of labor to build their own homes as well as those of their neighbors before they can move in. Besides increasing home affordability, the program also gives homeowners a sense of accomplishment and pride in their community.
Sweat equity can also be found in the relationship between landlords and their tenants. In exchange for maintenance work, building owners and landlords may provide an equity stake in the property or, in the case of a superintendent, free housing.
But what about the business world? Let's say 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 or $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.
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 instance, private equity (PE) firms may reserve a significant minority stake in acquired companies to incentivize management and align their interests with the PE investors.
How Do You Calculate the Value of Sweat Equity in a Business?
New businesses generally determine their valuation based on the sale of equity capital. For example, if an investor provides $1 million for a 20% equity stake, the company would be worth $5 million. Valuing a company can be more complicated without equity funding, in which case accountants will use the company's existing assets, brands, and the value of similar companies to estimate the total value of a company's equity.
How Do You Calculate the Value of Sweat Equity in a House?
In homes or other types of construction, sweat equity is based on the increase in a property's value that can be attributed to the owner's work, which would otherwise be paid out to professional contractors. For example, if you buy a starter for $100,000, perform repairs, and sell it for $150,000, your sweat equity would cost $50,000, less the cost of any tools, materials, or other expenses.
What Are the Downsides of Sweat Equity?
The biggest downside of sweat equity is the risk that the final value of your equity might be worth less than the work you put in. For new companies, workers take the risk that the company might fail, making their sweat equity worthless. Likewise, homeowners who perform their own construction assume the risks of poor workmanship that would otherwise fall to their contractors.
How Can You Use Sweat Equity to Reduce Taxes on Your Home?
If you make significant improvements to your home, you can itemize these expenses and deduct them on Schedule A of Form 1040. When you sell the home, you may be able to exclude any profit that can be attributed to sweat equity, such as construction, plumbing, or electrical work.
What Are the Tax Implications for Sweat Equity in a Business?
The IRS considers sweat equity to be a form of income. This means that if an employee receives part of their compensation in sweat equity, that equity must be included in the employee's gross income and can be taxed as such.
The Bottom Line
Sweat equity refers to the value of work performed in lieu of payment. Homeowners can build sweat equity by making their own repairs, rather than hiring a contractor. In a business, owners and employees may receive part of their compensation in sweat equity rather than a conventional salary.