What is the ratio of equity received for sweat equity vs. cash investment in a new venture?
There is no specific ratio between “sweat equity” and cash in a venture, and that’s actually not a good way to think about the issue. The bottom line is that cash is cash is cash, and everything else is “not cash”. The reason is that cash is fungible, which means it can be interchanged for everything else, from programming skills to vacations on the Riviera. Other things, such as your particular time and effort, are not.
A better way to think about this is to separate two aspects of the “sweat” that one puts into a new venture. These are critically different, and have very different economic attributes attached to them.
The first is the entrepreneurial value of the founder(s) in a new venture. This is what happens when someone starts an enterprise and creates something of value. So if you start a company, and then raise a round of angel investment at, say, a $2,000,000 valuation, the entrepreneurial value of the time and effort it took you to get to that point is…$2,000,000. The point is that the value created has absolutely nothing to do with a quantified effort that it took to get there. You might have created that value by slaving 18 hours a day, seven days a week for five years (in which case the value of the sweat equity is $8.70 per hour), or you might have created that value by having a brilliant concept, execution plan and team that you pulled together in two weeks of leisurely work (in which case the value of the sweat equity is $25,000 per hour).
The second component is the replacement cost of the specific skills and effort that are involved in the particular work. So if the same specific tasks could have been achieved by paying a programmer (or marketer or part-time CFO), say $2,000 on a short term contract, then that is exactly what the replacement cost value of the work would be.
In practice, once a company has been funded and a valuation established, “sweat equity” contributed after that point is usually compensated based on only the replacement cost number, either 1:1 (that is, the nominal salary, what you would have been paid if the cash had been on hand) is simply accrued, or some other ratio (say, 25% or 50% extra), in recognition of the fact that you’re willing to take the risk that it will never be paid if things don’t work out.
*original post can be found on Quora @ : http://www.quora.com/David-S-Rose/answers *
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This article is intended for informational purposes only, and doesn't constitute tax, accounting, or legal advice. Everyone's situation is different! For advice in light of your unique circumstances, consult a tax advisor, accountant, or lawyer.