Small businesses are built at the expense of their founders. Being the owner of two such ventures, I am intimately familiar with the idea of “sweat equity.” My husband and I have “sweated” a lot into our law firm and restaurant, and the contributions of our time and energy make our companies far more valuable than the stated fair market value of the fixed assets we own.
As an attorney working with small businesses, I have heard many stories from cash-strapped entrepreneurs. When evaluating companies, outside investors and lenders tend to be unimpressed with what founders think their own blood, sweat and tears are worth when it comes to valuation.
We all know the credit crunch persists and investors are skittish, unless you are manufacturing a medical device or you don’t really need the money. More than ever, owners are simply digging in to finance their great idea through their own hard work, time and resourcefulness.
The result is small businesses that are lean and mean. The problem is that owners have no clue how to value the time and effort spent developing the company beyond what exists on the balance sheet.
For companies that involve multiple owners, assignment of value for sweat equity is critical to allocate contributions of time and resources. If there are two owners and they each contribute services to the company during the startup phase, it is important to determine how much those services are worth. Although sweat equity does not create basis for tax purposes, it does require the owners to be honest and accountable to one another regarding their responsibilities and worth to the enterprise.
Put simply, the only way to determine the value of each owner’s contribution of sweat equity is to track that time and assign a monetary value to it. But so often, I see businesses work backward. They pick the valuation out of thin air, subtract the value of hard assets, and what remains is the value of the sweat equity.
This methodology is flawed and can be a quick indication to potential lenders and investors that the founders are unsophisticated and naïve.
But if you can’t work backward, then how should sweat equity be valued? The most straightforward way is to assign a value to the time contributed. This is relatively easy for lawyers, CPAs and consultants, who already bill by the hour and have familiarity with their worth in the open market. Assigning a number to the value of one’s time is more challenging when an owner is working outside their profession, working in multiple roles, or if the services being performed are difficult to value.
Using the opportunity cost method to value sweat equity has additional complexities. If Peyton Manning were your business partner, you would certainly not pay him the going rate for an NFL quarterback simply because he was helping you start a food truck.
In addition, “non-cash” adjustments should be made because a company should not be required to pay top dollar for the services it “purchases” from its owners.
Finally, sweat equity is effectively contributed on a pre-tax basis, while cash is contributed on an after-tax basis.
The key is to remember that sweat equity is still equity. It must be treated with the same seriousness and formality that any other contributions of cash would be given. Entrepreneurs should remember the true cost to themselves of investing their time and resources into a business in return for ownership.
More important, the owners should track and record the amount, manner and value of the services they invest. Recognizing the true character of sweat equity allows small-business owners to properly value themselves and their companies.•
Joseph is a partner at Joseph and Turow PC, a local firm specializing in small-business law and entrepreneurial services. She also is an adjunct professor at the Indiana University School of Law in Indianapolis. For more information, visit www.josephturow.com.