Sweat equity compensates management and employees for their effort
Definition
Sweet equity is financial instrument in the form of any options, non-monetary investment, that owners or employees contribute to a business venture. In other words, if you have startup company you will try to fund your businesses by compensating your employees with stock rather than cash.
There are different types instruments which are issued for sweet equity to increase the value of the management equity compared to the equity of other share holders, depending on how successful the investment is. The sweat equity can be issued as the rights to further shares, performance rights, restricted stock units or options.
Typically the shares for sweet equity are issued to the management team , only when there is a leveraged buyout (LBO) with a private equity(PE) partner. The sweet equity shares are usually issued at a price lower than other shares, to motivate the management by offering higher profits. These shares will ensure that the management will get a higher share of the equity sale money on exit.
Explanation
The management is not likely to access the sweet equity money unless the investors usually a PE fund get the profit they require, meeting the performance criteria specified in terms of internal rate of return on investment (IRR). This is usually 30% for the investors. The management team should get clarifications from the investors on how refinancing, equity issues, dividends, partial sales, and fees will affect the IRR to prevent disputes at a later date.
How sweat equity works
Other than money, owners and employees of a business also devote their time, resources to a business and this investment is the sweat equity. Since it is often difficult for startups and other entrepreneurs to offer high salaries to their employees who may be well qualified and experienced, they will use sweat equity shares to compensate their employees. It also helps to ensure that employees are rewarded for the risks they take. The employees hope to make a profit when the business is later sold. When homeowners make improvements which increase the property value, these are called sweat equity.
The directors and employees of a company may be issued shares at a discounted rate to retain talented employes. Performance shares are usually issued when the performance targets defined in terms of earnings per share or EPS, return on investment when compared to the index, and return on equity. The performance is usually measured over a period of several years. For example, the PE firms may insist that a minority stake in the companies they acquire is reserved, so that the management team, works to help the PE investors attain their goals.
Sweat equity for real estate and other assets
Construction and maintenance of property, other assets like cars, boats requires some amount of labour, and when the asset owner is spending his own time and energy to do the construction and maintenance work, this is considered to be sweat equity. Sweat equity can be used to reduce the cost of owning property. For example Habitat for humanity insists that property buyers spend 300 hours doing labour for their own home and others home, before they can take possession of the property. In a similar manner, landlords may give tenants a stake in the property, if they do maintenance work. Some real estate investors are able to repair the property themselves, and this is their sweat equity in the property.
