Putting sweat equity into your business

Starting and building a business typically requires owners to contribute capital, which can be in the form of property, cash, or assets such as office space, desks, vehicles, and equipment. Capital contributions can also be made in the form of services or labor, which is commonly referred to as sweat equity.

The basics of sweat equity

The term sweat equity is used in different ways. The most common meaning is to describe the services or labor that a person contributes to the business in return for an ownership interest, although this would be better described by the terms sweat investment or sweat contribution. Sweat equity is also used to describe the increase in the value of the company as a result of the sweat investment of services or labor.

For example, in a neighborhood of $300,000 homes, Fred buys a run-down house at a foreclosure sale for $200,000. He spends $50,000 for materials and performs the labor needed to fix up the house. The house now has a market value of $300,000. Fred's property investment is $250,000, while his sweat equity is $50,000.

Sweat equity can also build your company to the point where you can attract new investors. Let's say Wilma starts her business with $20,000 of her own money. After five years, she has built the company to the point that she can sell a 25-percent interest to an investor for $25,000. This makes the total value of her company $100,000, and Wilma's share $75,000. Wilma now has property equity of $20,000 and sweat equity of $55,000.

Multiple-owner companies

As long as a business is operated as a sole proprietorship, sweat equity is a fairly simple concept. But the situation can become more complicated if the company is organized as another type of business entity, such as a corporation, limited liability company (LLC), partnership, or other business entity with two or more owners.

Many small businesses with multiple owners are started and built without consideration of sweat equity. Each owner contributes cash and receives an ownership interest based upon their percentage of the total contributed by all. Each owner is paid for the services or labor that they perform as an employee of the company.

Another option is for all owners to simply work in the business as employees without compensation, deriving payment solely from their share of the profits. In this situation, all of the owners contribute both property equity and sweat equity, although the sweat equity portion is not formally recognized.

This can lead to problems if some owners come to feel that other owners are not contributing equally to the business.

In some businesses, owners may agree to contribute differently from one another. For example, some owners might make property contributions while others contribute sweat equity.

Sweat-equity agreements

Any time owners contribute sweat equity, there should be a written agreement to reduce the chances of disputes over whether adequate services are being contributed by the sweat-equity partners. Such agreements typically include the following types of information:

• A description of the services to be provided, such as the duties to be performed and number of hours per week
• The value assigned to those services, which can be based on an hourly wage, salary, the value of a product to be created, or some other method
• The type and percentage of ownership interest to be given
• When the ownership interest will be given, such as immediately or in increments as the work is performed
• Performance criteria that will be used to determine whether services are adequately performed

There can be a separate document or a sweat equity agreement can be included in the articles of incorporation, LLC operating agreement, or partnership agreement.

Disadvantages of sweat equity

In several respects, sweat equity can complicate matters. As stated above, it can lead to disputes between the owners. To reduce the likelihood of such conflicts, all owners should evaluate whether the proposed sweat-equity owner has both the necessary skills to do the work and the commitment to the company.

Care must be taken to assure that a sweat-equity arrangement is done properly. For example, an LLC sweat-equity agreement may require that all of the members agree to the arrangement or to admit a new member who will be contributing sweat equity.

A sweat-equity arrangement also requires additional record keeping, both to establish the sweat-equity contributions and ownership interests, and for tax purposes.

There can also be serious tax implications. In general, the Internal Revenue Service considers services and labor contributed as sweat equity to be taxable income. This applies to both businesses with multiple owners and a single-owner business organized as an S corporation, C corporation, or LLC. There are ways to structure the sweat-equity agreement to spread the tax liability over time, but this is fairly complicated and should be done with the help of a tax professional.

While a sole proprietor can easily reap the benefits of his sweat equity, it's much more difficult to do so equitably—and without conflict—when multiple business owners are involved. Before entering into a sweat-equity agreement, consider all the potential drawbacks and consider consulting with a tax professional for guidance.