What Is Sweat Equity?

What Is Sweat Equity?

I'm here to explain sweat equity, which represents labor-based contributions to a venture or asset instead of financial capital. You see, sweat equity is generally not monetary and, in most cases, comes in the form of physical labor, mental effort, and time. You'll commonly find it in real estate and the construction industry. In startups, it's the time and effort founders or team members invest when they can't yet afford to pay themselves.

Key Takeaways

Let me break this down for you: sweat equity is the contributions someone makes into a venture in lieu of payment. As a homeowner or real estate investor, you can use sweat equity to do repairs and maintenance on your own rather than pay for traditional labor. In startups, owners and employees typically accept salaries 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 it offers 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 landlord's responsibility.

How Sweat Equity Works

Sweat equity originally referred to the value-enhancing improvements generated from the sweat of one's brow. So when you hear 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. You can use sweat equity as a homeowner 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 below their market values in return for a stake in the company, which they hope to profit from when the business is eventually sold.

Important Note on Compensation

Cash-strapped businesses may provide compensation for an employee's sweat equity in another form such as shares in the company.

Formalizing Sweat Equity Agreements

When you contribute labor, expertise, or time to a venture in exchange for ownership rather than a paycheck, there are ways to formalize the arrangement. This type of legal document outlines the terms under which equity is granted and should clearly specify any type of equity split, including how much ownership you'll receive and when it will be issued. It should also detail the vesting schedule, which dictates how equity is earned over time; for example, you may not receive something until you hit a six-month benchmark.

In addition, any agreement should include performance benchmarks, such as hitting revenue goals or completing specific milestones, which can serve as conditions for equity allocation. For example, you may not receive compensation until a certain sales target is hit; at that point, you may receive equity or a cash bonus.

Formalizing sweat equity arrangements provides a clear record for tax and legal purposes. Without written documentation, it becomes difficult to prove the terms of the agreement, which can lead to serious disputes if the company succeeds or fails. Even though no money may be getting exchanged, that only makes it more important that particular metrics or items are written down and agreed to in advance of sweat equity being contributed.

Special Considerations

In many cases, you have to use sweat equity—your 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.

Fast Fact

Sweat equity is also used within personal finance where, instead of paying money to someone to do something, you do it yourself. One way to contribute sweat equity is to paint your own house instead of contracting that job out.

Example of Sweat Equity

Habitat for Humanity homeowners must contribute from 200 to 400 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.

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 may be able to exclude any profit that can be attributed to sweat equity, such as construction, plumbing, or electrical work, when you sell the home. You add the cost of home improvements, including costs for material and labor except your own labor, to the tax basis of your home. Increasing the basis reduces the taxable amount of your profit.

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. As a homeowner, you can build sweat equity by making your 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.