Editor's Note: Learn from a panel of experts and entrepreneurs who have successfully financed their own ventures and are helping others do it at the Thought Leaders Live 2013 event May 29, in Long Beach, Calif. Event and ticket information can be found here.
Entrepreneurs often ask me how to value the sweat equity invested in their startup. I used to offer a quick and easy response: It's worth whatever your investors tell you it's worth. But over the years, I have come to realize that sweat equity isn't the same thing as market value for your startup. Investors have no idea how to value sweat equity, and I now believe it's a bad idea to let them tell you how to do it. At a minimum, they could use this as a negotiating tool to undervalue your startup.
When you're getting started, sweat equity is often a critical component of your negotiating leverage with co-founders, early stage employees and others who aren't paid market wages to help you grow your business. As the business owner, you should be the expert on valuing sweat equity, not your investors, accountants or lawyers. Here are some tools for tackling the challenge.
When determining the value of the sweat equity provided by an employee or potential co-founder, first assess these three characteristics of the person in question:
- Commitment: Is he or she committed to being a founding partner for the long haul?
- Unique contribution: Does he or she bring specialized knowledge, skills, leadership ability or experiences that you don't have?
- Hopes and dreams: Are his or her hopes and dreams for personal wealth, business success and autonomy the same as yours? If not, are the differences substantial enough that they'll pull the company apart?
Then, start thinking about the numbers.
1. Market value doesn't equal the sum of sweat equity invested by you and your partners.
If you have invested $100,000 worth of your time in writing a business plan, and your partner, a young engineering student, has invested $25,000 worth of her time in building a prototype, it doesn't mean the market value of your startup is $125,000. In fact, it could be worth much more. Sweat equity is just one component of early-stage valuation. In a previous column , I discussed how valuing a startup is more driven by market conditions, comparable companies, exit potential, future capital needs and many other factors.
2. Foregone wages for an engineer aren't the same as foregone wages for a prototype designer.
In the example described above, the $25,000 estimated by your business partner is likely to be based on wages that she could have earned in a full-time job. This is the typical way that a founder determines sweat equity: foregone wages. However, your partner could just as easily have argued that her sweat equity is worth $250,000 since that's what a prototype would have cost you to make had you hired a prototype development firm. Or she could argue that the prototype is so critical to the business that she should get 50 percent of the company's stock.
In my experience, this is the basis for much of the negotiation that CEOs will have with their early-stage employees and co-founder. You need to determine the principle applied for valuing services invested in a nascent business. Foregone wages tends to be the anchor that keeps valuation negotiations from sailing into oblivion. Don't be tempted to dole out equity to everyone who helps you found the company--even it makes you feel good to have co-founders. (Being an entrepreneur is lonely, but there are better ways to make friends or build a community of credible supporters than by giving early-stage equity to people who make small contributions to your business.)
One simple solution is to "pay" a slight premium for sweat equity to early-stage employees. For example, when valuing the sweat equity invested by your prototype designer, use $30,000 rather than $25,000 as a valuation figure and explain that you're paying a 20 percent premium because of the risks associated with being paid in equity rather than cash.
3. Employees and founders are motivated by different things.
How should you decide if your prototype designer should be a co-founder who deserves 50 percent of your company or deserves $30,000 in sweat equity for her work as an employee or consultant? Too often, I see entrepreneurs make this critical decision by trusting the opinion of their investors--or potential investors--rather than determining what their business will actually need. First-time entrepreneurs often think "If I approach a VC with a chief technology officer or chief prototype designer in place, then I'm more likely to get funded." So they end up getting a co-founder and parting with 50 percent of their company, even if their CTO is really a young prototype designer who will get discouraged or fired a few months later.
Using a restricted stock agreement, you can mitigate risk, building in a buy-back right for the partner's equity grant. Ultimately, it's up to you. You get to decide what you need to give up to keep or get an invaluable partner on board.