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The value of sweat equity

By Roger C. Birong, CBA, CMC

 

rcbirong1Business owners often claim that the value of their company should include their “sweat equity.” Sweat equity, of course, refers to the long hours, dedication, and—in many cases—personal hardship, contributed by a business owner to his or her enterprise, especially in the early years, to make it successful. Sweat equity may also include the help of family members and friends who were willing to donate their time, effort, and expertise to help the owner get his or her new business off the ground.

This non-cash, intangible investment can often be substantial, and it’s not unreasonable to suggest that it should also enhance the value of the business. An owner initially devotes this time and effort with the expectation of reaping immediate benefits in the form of increased sales, improved financial stability, and higher income.

So the question is: Do such efforts also accrue to the economic value of the business in the long run? And what about a business that hasn’t fared particularly well, even though the owner has made a valiant effort to be successful?

Before you can determine if your sweat equity has any value, it’s important to understand a key principle: The value of a going concern is fundamentally a function of the present value of the future earnings the company is expected to produce for a new owner. In other words, a typical buyer of a business will invest capital only if he believes it is likely to render future earnings at an acceptable rate of return and that the profits from the business will allow him to redeem his initial investment within a reasonable period of time.

For a prospective buyer to determine to his satisfaction that a business can meet these expectations, he or she must first make a determination concerning whether he believes the company has the ability to generate an acceptable level of future earnings and then evaluate the risks regarding the likelihood that he will actually receive those earnings.

Characteristics of the business that can have a positive effect on these perceptions may include, among other things:

• A history of steady and predictable sales levels,

• Controlled costs,

• A good reputation in the markets served, and

• A roster of well-trained and reliable staff.

These attributes do two things:

1. They demonstrate the company’s historical ability to generate industry-typical earnings, and

2. They enhance the predictability of the business’s future, and, therefore, reduce the perception of financial risk. A buyer will be inclined to pay a higher price for the investment if he believes the risk is lower.

So, does sweat equity have a value? Yes, if it has ultimately contributed to the sustained financial performance of the business and the perception that it is reasonable to expect that the business will continue providing acceptable levels of cash flow to the owner. If sweat equity achieves those goals, its efforts will pay off in the form of a higher price.

Unfortunately, though, the value of a business is diminished if it is losing money or only marginally profitable, regardless of an owner’s contribution of time, treasure, and perspiration.

Roger Birong is a Certified Business Appraiser and a Certified Management Consultant. He can be reached at 904-641-3373, through his Web site, www.birongassociates.com.


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