Challenges in sweat equity valuation
With the number of tech start-ups on the rise and entrepreneurship spurring among young people I often see dedicated individuals who are putting a lot of time and effort in building worthwhile products or services. Oftentimes, after an initial basic validation of the idea, founders are looking to attract talented people on their team and are faced with cash-limitations which are overcame by motivating newcomers with sweat equity. In other words, sweat equity is a mean of remunerating individuals for their hard and salary-free work.
Entrepreneurs then have to judge how to best value of the sweat equity as this will also drive them in setting their expectations when negotiating with potential investors.
Personally, I find that carrying an objective sweat equity valuation is challenging. The starting point is naturally the foregone wages and yet one has to reckon that the valuation has to reflect the contribution brought to the value of the company. In some cases, to get there it is possible to use the Discounted Cash Flow (DCF) model to forecast the cash flows of the venture under two distinct scenarios: with and without the person in question. The value of the sweat equity would be derived by seeing the difference between the two. Such methodology can apply mostly where there is a quantitative way of measuring the contribution that one makes (eg Sales Managers, marketing managers).
What do you do however when you are dealing for example with a CTO? One could argue that the product might not have existed without him/her so how do you value the company without him/her? A workaround might be to assume that you would have used an employee and paid for the salary form alternative sources and yet there are many assumptions here that can easily be challenged. Probably what’s best in these situations is to agree in advance on the theoretical value of the total sweat equity owned to each party. That is, negotiate openly upfront so that you are clear on the expectations and avoid conflicts later on (this includes written agreement to document possible situations that can occur such as early departure). Once that is clarified, you can use the standard valuation models to value the company and determine what is the corresponding stake in the company for each sweat equity holder.