How to Account for Sweat Equity
Calculate the value of the business., Determine the value of each share of stock., Calculate the value of the sweat equity performed., Pay the person who performed the sweat equity.
Step-by-Step Guide
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Step 1: Calculate the value of the business.
Before you can determine the value of any sweat equity, you'll first need to determine the value of the business.
That's because you'll effectively be compensating somebody with "part" of the business.
You need to know how big or small a part of the business the person should receive in exchange for services rendered.
One way to calculate the value of a new business is by simply looking at the startup capital that's been put into it.
For example, if you put $250,000 into a startup, then the business is worth $250,000.
Use comparables to determine the worth of your company.
Check out how much companies like yours are selling for on sites like BizBuySelland BizQuest.Your company should be worth about as much as others in the same space and region.
Use discounted cash flow to determine the worth of your business.
If your business is already earning revenue, you can use a discounted cash flow model to calculate its worth.
That's where you value your business based on future cash flows.Value your business based on a multiple of current cash flows.
For example, if your business has a cash flow of $50,000 per year, simply multiply it with a valuation figure to determine the value.
You might multiply it by two or as much as five, depending on the nature of your business and the growth potential.Once again, check out how similar businesses are being valued to determine the multiplier that's best for your business.
Use a combination of the above mentioned methods and take an average.
There's no reason you need to isolate yourself to one method when valuing your business.
Use a variety of methods and take an average to get a solid valuation for your business. -
Step 2: Determine the value of each share of stock.
If you're business is a corporation, you'll need to know the value of each share of stock so that you can properly pay the person performing the sweat equity the appropriate number of shares.
For example, if your company is worth $500,000 and it has issued 100,000 shares of stock, then each share is worth $5.
For partnerships and LLCs, you'll be using be using percentages instead of shares of stock.
For example, you'll "pay" the person performing the sweat equity 10% of the company instead of 10,000 shares of stock. , You'll want to pay a fair market value for the type of work performed.
In this case, though, you'll do that with a piece of your company instead of cash.
Use the "foregone alternative" method to determine the value of the equity.
In other words, what could the person have earned if he or she had done the exact same work for another company? That's the value of the sweat equity earned.
How much did the sweat equity contribute to the value of the business? It may be the case that the sweat equity contributed much more in value to the business than the actual cost of labor.
For example, if you paint a house, you could earn $2,000 for the work.
This would be the market value of your work.
However, you might add $3,000 to the value of the house by painting it.
This represents the value added to the house based on the addition of your labor.
Both of these numbers are estimates, so actual amount of sweat equity may be in the range between the two. , Once you've determined the value of your company and the value of the work performed, pay the person who performed the sweat equity.
For example, if you value the work performed at $50,000 and your share price is $5, then pay the person who performed the work 10,000 shares of stock.
If your business is a partnership or an LLC, then the person who performed the sweat equity will effectively buy a percentage of the business with the sweat equity as opposed to cash.
Keep in mind that once you pay a person in stock for work performed, you can't take the shares back if the person stops working or doesn't do a good job.
In other words, once you give somebody 10,000 shares, you can't take them back.
That's why some people pay sweat equity partners an effective hourly rate in shares.
The more the person works, the more equity he or she earns.Payment for sweat equity in stock shares is a taxable transaction for corporations. -
Step 3: Calculate the value of the sweat equity performed.
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Step 4: Pay the person who performed the sweat equity.
Detailed Guide
Before you can determine the value of any sweat equity, you'll first need to determine the value of the business.
That's because you'll effectively be compensating somebody with "part" of the business.
You need to know how big or small a part of the business the person should receive in exchange for services rendered.
One way to calculate the value of a new business is by simply looking at the startup capital that's been put into it.
For example, if you put $250,000 into a startup, then the business is worth $250,000.
Use comparables to determine the worth of your company.
Check out how much companies like yours are selling for on sites like BizBuySelland BizQuest.Your company should be worth about as much as others in the same space and region.
Use discounted cash flow to determine the worth of your business.
If your business is already earning revenue, you can use a discounted cash flow model to calculate its worth.
That's where you value your business based on future cash flows.Value your business based on a multiple of current cash flows.
For example, if your business has a cash flow of $50,000 per year, simply multiply it with a valuation figure to determine the value.
You might multiply it by two or as much as five, depending on the nature of your business and the growth potential.Once again, check out how similar businesses are being valued to determine the multiplier that's best for your business.
Use a combination of the above mentioned methods and take an average.
There's no reason you need to isolate yourself to one method when valuing your business.
Use a variety of methods and take an average to get a solid valuation for your business.
If you're business is a corporation, you'll need to know the value of each share of stock so that you can properly pay the person performing the sweat equity the appropriate number of shares.
For example, if your company is worth $500,000 and it has issued 100,000 shares of stock, then each share is worth $5.
For partnerships and LLCs, you'll be using be using percentages instead of shares of stock.
For example, you'll "pay" the person performing the sweat equity 10% of the company instead of 10,000 shares of stock. , You'll want to pay a fair market value for the type of work performed.
In this case, though, you'll do that with a piece of your company instead of cash.
Use the "foregone alternative" method to determine the value of the equity.
In other words, what could the person have earned if he or she had done the exact same work for another company? That's the value of the sweat equity earned.
How much did the sweat equity contribute to the value of the business? It may be the case that the sweat equity contributed much more in value to the business than the actual cost of labor.
For example, if you paint a house, you could earn $2,000 for the work.
This would be the market value of your work.
However, you might add $3,000 to the value of the house by painting it.
This represents the value added to the house based on the addition of your labor.
Both of these numbers are estimates, so actual amount of sweat equity may be in the range between the two. , Once you've determined the value of your company and the value of the work performed, pay the person who performed the sweat equity.
For example, if you value the work performed at $50,000 and your share price is $5, then pay the person who performed the work 10,000 shares of stock.
If your business is a partnership or an LLC, then the person who performed the sweat equity will effectively buy a percentage of the business with the sweat equity as opposed to cash.
Keep in mind that once you pay a person in stock for work performed, you can't take the shares back if the person stops working or doesn't do a good job.
In other words, once you give somebody 10,000 shares, you can't take them back.
That's why some people pay sweat equity partners an effective hourly rate in shares.
The more the person works, the more equity he or she earns.Payment for sweat equity in stock shares is a taxable transaction for corporations.
About the Author
Andrew Miller
A passionate writer with expertise in lifestyle topics. Loves sharing practical knowledge.
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