When someone says they’ve invested “sweat equity” in a home or business venture, what they mean is that they’ve performed work as opposed to spending money on the project. While the term often refers to physical labor, any time and effort you devote counts as sweat equity.
Just as money you invest has value, so does sweat equity. Whether it’s worth your time and effort depends on how much value it adds to the venture.
How Does Sweat Equity Work in Real Estate?
As it applies to real estate, sweat equity refers to the physical labor, time and skill you put into a property — typically, one that needs remodeling and/or repairs. If you were to hire a contractor to paint the house, replace flooring, make plumbing and electrical repairs and landscape the yard, you’d build financial equity if the job added more value to your home than it cost you to have done. With a sweat-equity investment, you save the cost of hiring the contractor and do the work yourself.
To calculate your sweat equity in a home remodel or repair, you need to know a few things:
- The price you paid for the home
- The cost of materials and supplies
- The value of the time remodeling/repairing took from income-earning activities you’d otherwise have engaged in
- The value of the home after the work is complete
Add up the cost of materials and supplies and the value of the time taken from income-earning activities. Subtract the total from the home’s after-repair value. That’s what your sweat equity is worth.
Here’s how it looks in practice.
Example: Sweat Equity in a Home Remodel and Repair
For this example, you purchase a home for $200,000. The house needs drywall repair and fresh paint throughout, and the kitchen needs to be gutted.
- You purchase $500 worth of paint and supplies to take care of the drywall repair and paint job, and you spend another $25,000 on kitchen cabinets, counters, floor and backsplash tile, appliances and fixtures.
- You take three unpaid weeks from your regular job to do the work. That amounts to $4,500 in lost wages.
- You have the home appraised after the work has been finished. It’s now worth $275,000.
- Add up your financial investment, which includes $25,500 for materials and supplies and $4,500 in lost wages, for a total financial investment of $30,000.
- Subtract $30,000 from the home’s after-repair value: $275,000 – $30,000 = $245,000.
- Subtract the purchase price of the home: $245,000 – $200,000 = $45,000.
How Sweat Equity Works in Business
Similar to the sweat equity you put into a home repair, sweat equity in a business refers to rewards for contributions the founders and other individuals make to get the company off the ground. Rather than get paid a salary for their time and effort, the owners profit from the company’s growth. Other contributors, such as employees, advisors and board members, receive ownership interest in the company as compensation for their time and talent and willingness to take career risks for the sake of the new venture. In exchange for the equity they give up to these individuals, the owners profit from the sweat equity’s ability to attract and retain the best teams, which helps to further the company’s growth, as noted in a white paper by the Michael Best and Venture Best law firms.
You need to know the values of several variables to calculate sweat equity in a business, according to FortuneBuilders:
- The value of the business
- The value of each share or each percentage
- The value of the labor contributed to the business
Here are the steps to do the calculation:
- Divide the value of the individual’s contribution by the percentage of equity awarded to them.
- Subtract that figure from the value of the business.
- The resulting figure represents the value of the sweat equity.
Example: Sweat Equity in a Business
Say, for example, you start a business to manufacture and sell the next best thing in consumer electronics. The business isn’t making any money yet, so you can’t draw a salary. You’re betting that your reward will come once the company starts generating big profits.
Your employee is in the same boat. You can’t pay them a salary, so you give them a 1% stake in the company. Here’s how that might play out:
- Assume the value of the company to be $2 million.
- The employee has done $100,000 worth of work.
- The employee’s 1% stake is worth $20,000.
- Divide the value of the employee’s work by the company’s value: $100,000/$2,000,000 = 0.05, or 5%.
- The employee’s contribution is worth 5% but you’ve only given them a 1% stake, which represents a positive return on your investment.
Is Sweat Equity Worth the Work?
Sweat equity can be worth the work if it frees up cash you can use toward other things, such as buying an investment property or growing your business. However, it can be problematic in some instances.
In the case of a business, the sweat equity you give to employees and others comes at the expense of your ownership interest in the company. It can also cause conflict between owners, LegalZoom warns, especially if the individual receiving sweat equity lacks the skill to do the work effectively or lacks commitment to the company. Note, too, that the IRS taxes sweat equity as income if the business has multiple owners or is structured as a C or S corporation or limited liability company.
Sole proprietors, on the other hand, can benefit from sweat equity while avoiding the complications of other business structures.
Sweat equity can also cause problems in real estate. You’ll have to invest money no matter what, even if only on supplies and materials. And unless you have remodeling experience, you’ll also have to invest time to learn how to do the work. It might be worth it if you do a great job. However, a poorly executed remodel or repair can actually reduce your home’s value rather than bolster it. If you’re unsure about your ability to do professional-quality work, you’re better off leaving it to a pro.
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- Corporate Finance Institute. 2023. "Sweat Equity."
- LendingTree. "How to Use ‘Sweat Equity’ in Real Estate."
- LegalZoom. 2023. "Putting sweat equity into your business."
- Venture Best. "Entrepreneurs' Introduction to Sweat Equity: Using Equity to Recruit, Retain, and Incentivize the Team."