I’ve bathed in sweat equity before. I went several years without salary at Palo Alto Software, once in the beginning and again when we hit the downturn in 2001. I didn’t have a choice; there was no money to pay me. You build a company, sometimes you have to settle for what’s possible.
I made this mistake the first time: I just worked for free. I didn’t do anything about adjusting the company books. We didn’t have any profits, so not expensing my labor didn’t matter much. We had enough to worry about, anyhow, keeping the mortgage paid and the kids in shoes with consulting revenue. Palo Alto Software was still not much more than me stubbornly working a business plan.
The second time around, I knew better. I recorded my value as a loan owed to founders, and the payroll tax implications of my value as accounts payable. That way, I had two advantages:
First, an accurate rendering of reality of the company. My value is part of normal expenses. It doesn’t do anybody any good to underestimate expenses.
Second, it established an amount to be dealt with later. And also the related tax liabilities.
There are details to watch for with salaries owed to owners, because you can’t deduct them unless you’ve actually paid them; and when you do actually pay them, you owe payroll taxes as well.
When I read business plans for startups, I don’t like to see founders working for free. It understates actual expenses. I do understand the necessities that arise, so I can accept founders discounting themselves to build a company. But I like it better when they document their worth carefully, like I did in the second case of sweat equity.
Imagine then my surprise when a presenter at an angel investor meeting last week bad-mouthed the idea of owners recording lost salaries as debts. I think it’s a good thing. He–and he is in a position to know–made it sound ridiculous. Apparently he took it as a claim for money to be paid to the owners the moment capital is raised from investors.
I disagree. I think recording the value of unpaid sweat equity is better for all, because it’s there, it happened, and–as long as you manage the tax implications correctly–it means your expenses are more accurate. It doesn’t mean you’re demanding to be paid in full the moment you get an investment.
Case in point: After things got better, I swallowed the sweat equity. It disappeared off the books and became de facto capital. Not formal capital, because that would have required different tax treatment; but de facto capital, because capital is assets less liabilities, so when the liabilities shrunk, the equivalent amount became earnings. So taxes were paid.
I’m not going to rule out a venture because its owners have kept track of the value of sweat equity. I’m not going to expect investors to pay them that amount, either.
Tim Berry is the founder and chairman of Palo Alto Software and Bplans.com. Follow him on Twitter @Timberry.
