Imagine starting a business with a rich friend. Your friend has money, but no experience or industry knowledge. You, on the other hand, have experience running a business and specific industry knowledge, but no money. When you form a partnership, you might strike a deal with your wealthy partner to "earn" ownership in the company by working in it. Your contribution is in time, expertise and contacts. Your equity in the company will grow over time as you work on developing the business from day to day.
Valuing Sweat Equity
When business partners enter an arrangement where one partner will be compensated in sweat equity, it is important to agree on an accounting mechanism. For corporations, this can be the gradual transfer of shares to the sweat equity partner over time as his investment in time and effort grows. For partnerships, it will require the careful administration of capital accounts, tracking the contributions of each partner in terms of time and capital -- either in cash or in property -- contributed to the business.
Wage and Share Calculation
A simple way to account for the sweat equity of one or more partners is to agree on the dollar value of a share of stock in the company, and to agree on a "wage" for the efforts of the laboring partner. In this way, the partner will earn a set amount of shares, or a percentage interest in the company, per hour, day or week's worth of work. Compensation can be entirely in the form of stock or equity in the company, or a combination of wage income or salary and equity. Equity income is taxable to the recipient, just as cash income is, though there is generally no Social Security or Medicare tax due on it.
Valuing the Entire Business
Another common definition of "sweat equity" refers to the difference between the owner's total contribution of capital, or basis, in the company and the company's market value. When investors value a company at a higher price than the sum of its assets and liabilities, the difference must have come from the hard work and industry of the owners. When they sell the company, the owners will reap the benefit of their sweat equity.
Sweat equity could also refer to a form of executive compensation. When executives are granted shares of stock in a company as a reward for their diligence, they have in effect, been granted equity in return for their sweat, or their efforts in making the company successful. This can be part of a formal executive compensation plan, with a set number of shares granted in exchange for meeting specific objectives, or it can be part of an ad hoc bonus program.