The concept of sweat equity is one of the most damaging ideas in entrepreneurship. The term “sweat equity” fools entrepreneurs into thinking that effort alone is sufficient to create value. The application of sweat equity (also known as “effort”) is often (but not always) necessary to create a valuable venture, but it is never sufficient. We hear a lot about sweat equity in the entrepreneurial world. Sweat equity from founders. From advisors. From service providers. Accordingly, I’m asked frequently about how to value sweat equity. “How do I value the work I have invested in my startup?”, I’m asked. I’m going to let you in on a little secret. Sweat equity is worthless, because it doesn’t actually exist. It’s made up, or at best, it’s a misnomer. Equity implies that an asset exists somewhere. The concept that sweat equity is false is a perhaps harsh, yet important lesson because I hear entrepreneurs talk about their sweat equity and it breaks my heart because they are setting themselves up for disappointment and failure. As an entrepreneur, you must have the mindset of creating assets because assets are something the market will pay for. Assets are the source of value, not work. Indeed, your goal ought to be to create the most asset value with the least amount of effort.
Here is an example of why “sweat equity” is not the appropriate way to think about value. Suppose you are looking for $1 million in investment for a startup, and you argue that your contribution is sweat equity. Not an asset, but the work you’ve put in. What kind of startup doesn’t matter. If you are somehow able to secure the investment you are seeking, the valuation will look something like this:
Sweat equity + invested cash = post-money valuation.
$0 + $1 million = $1 million
Which means the investor will (and should) own 100% of the company. You aren’t a shareholder – you’re an employee. Of course, in this case there is no point in making an investment, and so the capital raise fails unless an investor makes a mistake.
Why isn’t sweat equity an asset? There is no marketplace for sweat equity. Sweat equity doesn’t appreciate in value. Sweat equity is the sunk cost of labor withheld from the market to be applied to the development of something that might actually become an asset. Sweat equity is a form of investment, and, like all startup investments, there is no guarantee that the investment will pan out into something productive and valuable, such as an invention, or a new product or service, or attracting customers. When you go to market to raise capital, investors are no more impressed by sweat equity than they are by previous investments as both are sunk costs; they are impressed by the assets that such investments of labor and/or capital have produced. If you raise capital to buy labor, and the labor doesn’t pan out into an asset, you generally can’t recover your money. Just ask the Red Sox about Pablo Sandoval.
Yet, many of us have been trained, to believe that the market values labor. The fact of the matter is that the market does not value labor – at least not all that much. If you don’t believe me, ask anyone who’s job has been replaced by a robot, or an ordering kiosk, or a kid. Indeed, capitalism is all about avoiding labor. Labor is a necessary evil in the capitalist world, because labor doesn’t guarantee useful output. When we buy labor, we buy time and effort (and sometimes sacrifices of long-term health – such as coal miners, NFL players, and the guy who used to host Man vs. Food.) Marx was right about the perpetual struggle between capital and labor, and capital usually wins in a capitalist system unless and until the system is overthrown, or there are laws in place to protect the status and rights of labor and artificially create value – such as the right to organize and collectively bargain. (There is a funny Russian expression that if you read Marx, you are a communist. If you understand Marx, you are an anti-communist).
Nobody wants to buy labor. Firms only do so when absolutely necessary. Low wages, the disappearance of defined benefit pensions, self-driving cars, $700 miracle hand-held supercomputer-phones – they all scream at the top of their utilitarian lungs that labor is a plague, not a cure. As a former colleague in Minsk once said to me, “Socialism pays you for work and capitalism pays you for results.” You want to tell me the Russians’ don’t get capitalism?
What investors do want to buy are assets – and the assets that are generally created in a startup include technology or inventions, business models, customers (or customer intelligence). Assets can appreciate and thus generate return – the whole point of an investment.
With this in mind, let’s revisit the investment balance sheet, with the assumption that the effort the entrepreneur has applied has resulted in an invention (an asset) that the market would value at $2 million:
Invention + invested cash = post-money valuation
$2 million + $1 million = $3 million
And now, as the founder, you retain 67% of the company. You are an owner, not just an employee, because there is an actual asset to own.
As illustrated above, the value in startups does not arise from the effort invested in a company. When you argue value from a perspective of “sweat equity”, you are asking someone to pay you retroactively for your effort – to try to be paid as an employee and a founder at the same time. You can’t have it both ways. The source of value lies in what that effort has produced. If you are thinking about valuation for a startup company or project, the compelling argument is about the asset you have created (or obtained). Conversely, you can slave away in your company for years, forgoing years of income, draining your savings, straining your personal relationships – but if you haven’t produced something with that effort that the market finds worthwhile, you’ve got nothing to sell.
The call to action here is simple. Excise the term “sweat equity” from your vocabulary, and replace it with “asset creation”. The concept of sweat equity is insidious in that it implies that simple effort must lead to value created, and that simply is not the case. Sweat equity gives you a subtle mindset of being labor, rather than capital, and it even can give you a sense of entitlement – since I have performed labor, someone ought to pay me for it. We admire people who work hard (and we should), especially those who work tirelessly for no compensation in pursuit of an uncertain pay day. But no amount of admiration will pay your mortgage.
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