Ask the Expert – Sweat Equity 1

Question

There are two partners. One partner has invested a large amount of cash. The other has invested strictly time, which if fairly valued would also be a large amount of cash.

Is it reasonable, or acceptable to indicate the value of time invested in the form of a cash value as a “Startup Expense” Investment?

Answer

This issue is called “sweat equity,” and it comes up a lot.

Obviously, fairness is vital. Both partners should believe in the deal, and both should feel fairly treated. Both have to respect what the other partner contributed. Otherwise you’ve got a long-term disaster waiting to happen.

Whenever you can, you should always deal with these issues before contributions are made. Talk it out before anybody puts in either the time or the money. Both time and money are frequently worth more before they are spent than they are afterwards, when the spender can’t get them back. If either the time or the money is undervalued by either partner, then don’t go forward.

Photo by Gary Simmons

Photo by Gary Simmons

However it seems like in your case both time and money are already spent and now you’re negotiating a deal. Better now than later, always. You don’t want to start a company based on unfair ownership structure.

The best way to do it is the simple way, with shares of ownership. Talk it out between the partners. Decide what a fair recognition of sweat equity is, and give that partner a fair proportion of total ownership, which is usually a matter of stock. You don’t have to have millions of shares, I’ve seen companies started with 100 shares. Give fair shares to both partners.

You can invent fake money to tie into sweat equity, but there are problems you should be aware of:

  1. When you put money into investment, standard financials assumes it’s there to spend. Sweat equity isn’t. Therefore, you have to balance that amount of money in the start-up table with the same amount of start-up expense. Specifically, if I put $50,000 into the start-up table as an investment value, based on sweat equity, then I have to put the same $50,000 into the start-up expenses as compensation. Otherwise I overstate my starting cash by $50,000. And double entry bookkeeping requires both entries. The one explains the other.
  2. This fake money also increases the loss at start-up. So for example if the sweat equity value was $50,000, and the compensation of $50,000 means  the loss at start-up increases by $50,000 too. You can’t get around that, if it has a value, then that value is spent.
  3. You might have to pay payroll taxes on this amount to make it fully legitimate. For this detail you need to consult an attorney or CPA, or both. We aren’t in a position to give professional advice of this kind on this forum, but this is a possibility. By the time you’re calling it an expense and a capital input, you should at least ask.

LivePlan can handle this however you want to, the software doesn’t care, but you should be aware of some of these extra considerations.

And if you decide to handle this the simple way, with who owns how many shares of stock, the good news is that while that subject should be covered in text, it doesn’t affect the direct financials of the company. “Paid in capital” does, of course, and that’s what the investment input is. But who owns how many shares of stock doesn’t affect cash flow, income statement, or balance sheet, so it is dealt with in text only.

Tim Berry

About the Author Tim Berry is the founder and chairman of Palo Alto Software and Bplans.com. Follow him on Twitter @Timberry. Follow Tim on Google+ Read more »

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