Definition - What does Sweat Equity mean?
Sweat equity is ownership interest or an increase in value that is created as a direct result of hard work by the owners. Sweat equity is a form of compensation by the business to their owners and employees. It is recognition of a partner's contribution to a project in the form of effort while financial equity is the contribution in the form of capital.
Divestopedia explains Sweat Equity
Sweat equity is ultimately a form of capital. In a startup company, employees may receive stock as partial payment of their remuneration, thereby becoming part owners of the firm. This is a preferred mode of building equity by startup ventures in the early cash-strapped years. Work done for little or no pay by the partners of the firm in the initial years are rewarded in the form of sweat equity. Sweat equity is also used to retain talent in the firm. Shares are issued at a discount by a firm to its directors or employees as a consideration for their services and know-how. The employees become part owners and participate in profits.
A merger and acquisition transaction has a major impact on the partners, staff and clients of both firms. Traditionally, the capital required of a new partner was a fixed cash amount. In established firms, actual pro-rated value of a firm is different from the amount of cash contributed as capital. The value of most firms decreases as it adds lateral partners. So the seller or original partners want to maximize the value of years of sweat equity.
Private equity firms may also issue stock to acquired management teams based on the fair value of their sweat equity contribution made to the investment.
The term originated from value-enhancing improvements generated from the sweat of one's brow. Now there are various regulations on the number and time limit for issue of sweat equity shares.