Sweat Equity and Outside Finance: The Ups and Downs

When starting up a company, the first question to arise is a financial one in nature. Where will the resources come from? Where will the funds generate?

Although there are start-ups that have been self-started, not every entrepreneur with a vision will have the available financial power to get their idea off the ground. But this hasn’t stopped business-minded people to look for other ways to obtain the requirements to pursue their endeavors.

Two of these ways come in the forms of Sweat Equity and Outside Finance.

From the term ‘sweat’, equity in terms of perspiration refers to offering part of the start-up ownership to an individual who has exerted effort into providing help to getting the project started. This could come in the form of labor, knowledge or skills that a person can contribute to the beginning of the company. Contributors are then entitled to shares of the company. This gives them partial ownership of the company in exchange for their efforts. In this sense, contributors become co-founders along with the entrepreneur. The success is shared at a lower cost to the original owner.

Outside financing is a more traditional approach wherein an external investor is persuaded to contribute either financial aid or manpower from their personnel to help the business lift off. It is considered as a debt on the end of the entrepreneur which he/she will have to pay over a certain period of time, depending on the agreement between the creditor and the debtor. In this method, the entrepreneur retains sole ownership of the company but at the price of a debt to their creditors.

As with every business decision, each method has a set of advantages and disadvantages that can affect the decision-making process. These differences commonly results in a trade-off between power and control over the start-up:

PROS

It is certainly more affordable for a would-be business owner to share ownership of their company with the people who contribute to its initial growth. Instead of paying co-founders for their efforts, they are entitled to shares of the company either for free or at a discounted price. The original owner no longer has to pay any debts to anyone because they’ve already been paid for in terms of ownership.

On top of the lower cost, sweat equity gives potential business owners a partner or set of partners to which they can fall back on whenever problems arise. Since ownership is shared, difficulties are shared as well. Instead of just having one person worry about a particular issue, several concerned and attached individuals are involved which makes problems easier to handle and overcome.

For outside financing, cost is traded for freedom. Since ownership is not shared, the decision-making powers all lie with the owner. There is no need to consult with a board or have deliberations about certain decisions regarding the growth of the company.

Along with this, sole proprietorship enables owners to fully enjoy the fruits of their labor. With no one else to share the profits with, the proprietor can most certainly keep all the earnings and use them as they see fit.

CONS

In exchange for cost, sweat equity entails shared success. Profits are divided in between co-founders. This also means a division of power and control over the company. Founders may find themselves in disagreement over a number of things. Given the early nature of the business, disagreements between founders are further maximized by the pressure of making the business grow. It may not be a wise decision for a would-be owner who has a very strong claim to their vision to share control with other people.

Another challenge with sweat equity comes into quantifying how much effort is worth how large of a portion of the company has to be shared. Many business magazines and experts have their own ways of attaching quantifiable values to effort. Although it may sound like an abstract concept, it is a viable option for owners who are willing to share a portion of their companies.

With outside finance, the burden of paying off a debt can be just as difficult. This is because the debtors’ capacity to pay off the debt will heavily rely on the business generating a desirable profit for the owner. If the business fails, the owner finds oneself in a very difficult situation. With sole power comes sole blame. There will be no one to turn to if it turns out that the original idea was not profitable at all. Most hopefuls overcome this problem by getting advice from experts to see if their plans are going to be profitable or not. This helps them make better decisions to avoid painful failure.

Ultimately, the decision between the two will strongly depend on how firmly the hopeful feels about their business idea. The stronger the conviction, the riskier the choice. If the owner thinks the idea will sell, they may be more inclined to get outside financing. If they feel their idea needs more help in other areas, then they might opt to get expertise with foregone wages.

Which is why it is important for those with business ideas to seek advice and do research about their proposals. The more prepared and well-informed a decision is, the more predictable the outcomes become. When the outcome is more predictable, it becomes easier to think of solutions around undesirable results. It is a smart choice to prepare for the worst rather than to expect the best.