Let me start with the caveat that I am not a lawyer and you should not construe this article as legal advice and you should seek legal counsel on all matters of corporate governance and taxes. In addition the laws may be different from state to state so do your research and consult an appropriately licensed expert.
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.Read more: Sweat Equity
Mark Cuban thinks sweat equity is the most valuable equity there is and I tend to agree. He looks at it from the perspective of someone that is currently buying his portion of the equity verses the person who is working to earn their share of the equity like he often used to when he was in start-up mode. He started virtually all his business on his own, building value without outside investors as he believes once you accept money you are no longer the one in control.
When you are in start-up mode, you control everything and you can build incredible amounts of potential value before you ever incur any hard costs if you have some expertise or intangible asset such as a proprietary idea, contact network or training content that someone else doesn't have. But if you can't build that asset on your own because you need other people or infrastructure to make it work, then you need to consider an outside source of capital.
So you have decided you can't go it alone and you wish to unlock whatever special value you think you have by selling it to the public but you believe for some reason that is not possible the way you envisioned without some cash investment to make it happen. You find yourself in a position of not being able to unlock it's value without a financial partner to help create the value by adding cash to the equation. This is important, as you are saying you don't have anything of value until more value gets added to it and hopefully it is worth more after the extra value is added. Essentially you only have half a bottle which is worthless if your customers only wish to purchase a whole bottle. So in this case, the upfront financial value is every bit if not more important than the work that is yet to be done and the success that is yet to be proven as their is no value without it. If you can go it alone without the capital you should, don't be lazy expecting capital to allow you to coast because the investor will not let you.
My experience and that of virtually all financial investors I have worked with, is that the above scenario is quickly forgotten by the sweat equity partner. Financial investors begin to believe that the cash investment is not respected by the sweat partner. This isn't the way the sweat equity partner sees its though. The sweat partner works all day and doesn't see the financial investor in the business along side them, even though this is the way both knew it was going to be. The days of a start-up are long and tiring and although the sweat partner would have promised their first child and 80 hour weeks all year long to attract the investor to invest, the reality is that it gets old fast and they fall into a state of animosity which is where the notion that the investment is no longer respected stems from.
So why does the financial partner view their investment as being different from day 1?
Let's look through the lens of the partner who is putting up the money to buy their equity. If a company requires $250,000 in capital to get started, in all likelihood the financial partner will have worked for several years to earn the $250,000 before they can make the investment. So they are already 100% at risk day one or let's say within the year it may take to fully invest and get the business off the ground.
The investing partner already put in what could be construed as maybe 5+ years worth of work at an average salary of $50,000 per year to make this investment. In fact they may have worked 80 hour weeks themselves to have $250,000 to invest not to mention they have to pay taxes on those earnings before investing what is left of their income. So the thought process of a typical financial investor is that they had to work approximately 6 years at approximately $60,000 per year and paid their fair share of taxes to have $50,000 per year leftover that they could put away each year for 6 years to invest in this project. Thousands of hours of hard work to get to this point. As far as they are concerned, they have already made a huge commitment to the partnership and worked thousands of hours and now are looking towards the sweat equity partner to do the same over time to earn their percentage of the partnership, or whatever is agreed upon.
My experience is that the sweat equity partner is rarely willing to do this for an equivalent 6 years or whatever amount of time is considered a fair exchange of work for equity in this situation. In addition they expect to be compensated as well as without any income they can't survive. So the nature of the equality and fairness of the equity is in jeopardy at its inception.
If you are compensated, can you be earning anything other than your salary?
So just how does a sweat equity investor earn their sweat equity? Let's move to Part-2