Sweat Equity
It may sound cliché, but contrary to popular belief, sweat equity is legally recognized as capital and is as valuable as cash equity.
Sweat equity is a funding model commonly used by startups.
It compensates the founders and/or stakeholders for the work and time they contribute by giving them an ownership stake in a company.
It can be a useful way to fund a startup and attract top talents but you need to understand how it works before deciding if it’s right for your business.
This practice can come especially useful to navigate several operating constraints requiring the necessary upfront capital (i.e. cash), especially in the following scenarios:
1. Equitable compensation for people who helped found the company
This is desirable if you intend to quantify the effort you will be putting into the business.
In this setup, upon incorporation, you will value your efforts which may be made on top of the cash capital you will be infusing.
For example, you and your two friends decided to create a company. You all agreed and decided to invest 150,000 for each of them as cash, and you will invest 200,000 in cash and your industry as the main business overseeer over the next 6 months with an agreed upon valuation of 150,000.
Therefore, your capital would be:
Cash Capital: Php 200,000 or 20,000 shares at Php 10 par value
Non-cash Capital: Php 150,000 or 15,000 shares at Php 10 par value
Total: Php 350,000 or 35,000 shares
Their capital would be:
Cash Capital: Php 300,000 or 30,000 shares at Php 10 par value
2. Navigate cash constraints to sustain operations of the business in its early stages
In this setup, once launched, you will have the option to offer potential hires a salary. Assuming you will be faced with upront financial capital to pay for salaries, you have the option to offer them a sweat equity stake (or a combination of a lower salary plus sweat equity).
With the sweat equity option, you can offer employees a percentage stake in the business in the form of shares instead of salary.
You don’t have an upfront cost with this option, which is why it can be a great option for cash-strapped entrepreneurs, but you are giving up potential future value by decreasing your ownership stake in the business.
For example, you will cumulatively give out a total of 100,000 worth of shares at P10 per share as equity stake over the next six months.
The new capital composition would be:
You: Php 350,000 (35,000 shares or 46.67%)
Friend A: Php 150,000 (15,000 shares or 20.00%)
Friend B: Php 150,000 (15,000 shares or 20.00%)
Employees: Php 100, 000 (10,000 shares or 13.33%)
New Total: Php 750,000 (75,000 shares or 100%)
Note: in this example, the individual share capital vs. total infused capital was used as the basis in the recomputation of share percentage.
Assuming that no objections were made on the admission of new investor, The value of the sweat equity may be revalued in the future, most often in cases of capital re-infusion.
For example, another investor decided to invest P300,000 in your company for a 15% ownership (remember the 15% ownership agreement).
The value of your capital will increase. To clarify, the computation would be:
Old Total: Php 750,000 (75,000 shares)
Your investor: Php 300,000 (30,000 shares or 20.00%)
Unadjusted Total: Php 1,050,000
Since there should be revaluation of capital due the agreement of 20% stake of the new investor, your readjusted capital would be:
You: Php 793,390
[79,390 shares or 39.67% (2M - 20% x 46.67%)
Friend A: Php 340,000
[34,000 shares or 34.00% (2M - 20% x 40.00%)]
Friend B: Php 340,000
[34,000 shares or 34.00% (2M - 20% x 40.00%)]
Employees : Php 226,610
[22,661 shares or 11.33% (2M - 300K x 13.33%)]
Your investor: Php 300,000 (30,000 shares or 15.00%)
Adjusted Total: Php 2,000,000 (200,000 shares)
Capital gains of Php 950,000 will have to be distributed to all shareholders based on their share percentage immediately prior to the admission of new investor.
Note: in this example, the agreed upon percentage stake of the new investor, which is 15%, was the basis in the recomputation of shares of stocks value.
In the foregoing scenario, the sweat equity you've invested is now worth Php 340,024 (42.86% of total capital oustanding).
These are just examples and may also be affected by several factors, including, but not limited to: the accounting methods employed by the company, the company's performance, board decisions, existing policies on admission of new investments and provision of stock options, the type of shares of stocks, and the current socio-economic conditions of the country the company is operating in.
But this provides a proof as to how far your "sweat" equity could take you.