Valuation of Sweat Equity in a Project
Entrepreneurs may find it difficult to place a value on uncompensated hard work, or sweat equity, that has been invested in a new company or specific project. Some may accept whatever value investors are willing to pay for it. However, there is a way to substantiate the value of sweat equity for partners and employees that prevents partners' or employees' work, and the business, from being undervalued
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Sweat Equity
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Some use the term "sweat equity" to imply that an employee has a right to compensation because of all the hard work invested in helping build a company through projects such as completing a new software or technology product. Sweat equity is common in start-up environments. It implies work performed that is generally in excess of a normal job description, and compensated at a less-than-market-rate salary for the position. Offering future compensation for current efforts is part of attracting and retaining good employees in a start-up environment. The company owner, more than anyone, needs to understand the value of these contributions.
Valuation of Sweat Equity
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When valuing a project as a component of an overall company value, consider comparable companies, future capital needs, potential growth and market conditions. This accounts for the value of the venture over and above the time an owner has spent writing a business plan or a partner has spent building a prototype of a new product. It is important for an owner to perform this assessment -- letting investors, lawyers or accountants decide the value of sweat equity is dangerous because they could severely undervalue the company. A cash flow analysis can derive the value of a project, but that value must also fit within the scope of the organization's overall range of value.
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Forgone Wages
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Each employee has a different value for unpaid wages. Determining the value of sweat equity depends in part on the market salary a person could have earned working full time for an established company. To this basis, a small premium could be added to pay for expertise he provided that would have normally been contracted out, such as building a prototype. A partner may also deserve a premium because his technology contribution is critical to the business. Supporting the value of the employee in a project valuation model may also involve adding a small premium to compensate for the risk of the employee receiving equity compensation rather than cash.
Restricted Stock Agreement
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Depending on the scope and importance of the project, an owner should consider whether an employee should have equity in the company or could be paid a lump sum for sweat equity. Some employees would be happier with direct compensation, and not every employee may turn out to be a long-term fit for the company. A restricted stock agreement with a buy-back right can help reduce risk. If an employee is granted equity, the company can buy the shares back if the employee does not work out as well as anticipated.
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