What is your Sweat Equity worth and how do you calculate it?
A pre-money start up or early stage valuation is definitely the most difficult to value (vs an established business) but there are some rules. For example, at the very minimum, a business is worth at least 100% of the invested capital. £100,000 cash invested = 100%. You can dilute from there keeping the same percentages as post money starts to come in.
On the other extreme, one can make an argument that a business is worth what it ‘should’ generate through future earnings. For example, if an entrepreneur makes the argument that their business will generate £1 million in sales and £250,000 in profit each year over the next 3 years (or any number of years), and an investor comes in at £250,000 for 50% equity, they will see a return of 50% per year based on their investment.
Will it actually happen?
That’s the tough part, maybe, maybe not, but that is all part of the game.
In the middle of all this is some estimate of cash invested, future earnings, sweat equity, future rounds of finance, etc. It can get very complicated and subjective. Be VERY cautious about future earnings because if they happen, they happen because of BOTH the founder and angel investor’s investment and if they are taking common stock in the company just like you, you both go up and down as things progress. If an angel investor can bring other things to the equation such as physical involvement, industry contacts and leads, overhead infrastructure etc. they might insist on deducting this from their proposed equity offering.
So how much time and money have you invested so far as the founder and what percentage of the total investment you are seeking would you say your sweat equity is worth? Every business in start-up or early stage has a founder that has invested a great deal of time.
Your business is likely no exception and your sweat equity is worth something. Coming up with an exact figure or percentage sometimes requires further investigation but as a loose rule, you should have no problem making the argument that 20% of the total capital invested to date (personal, angel investment, banks and government funding) would be reasonable as the founder’s value of their sweat equity.
Venture Giants Insider Edge:
A good rule is to look at and base things on the initial cash investment from the entrepreneur (plus anything you have personally guaranteed because you are on the hook for this as well), and allocate 20% of this total as sweat equity.
Other resources on Venture Giants related to Sweat Equity and its calculation is how much Equity is enough? No surprise that most entrepreneurs will over-value their companies in the start-up stage and either ask for more than required, or offer less shares than is reasonable. Understanding what your sweat equity is really worth (using the formula listed above as an example) is the first step towards being in a real position to determining the amount of equity you should offer in return for angel investment.
Most angel investors will want to know the rationale for your claims when it comes to calculating your yearly growth projections and the figures in your business plan. It is extremely important that you can demonstrate a clear understanding of the size and scope of the industry in which you are focused on. How do your projections compare with the yearly revenues and overall growth forecasts by industry experts? Placing overly ambitious yearly growth projections in your business proposal may leave your sweat equity figures under scrutiny as well – so the key here is to be realistic on your projections, especially if you have invested a significant amount of time and cash into your business. If you state that your proposal has a 1000% ROI in year 1 and then state that your sweat equity is worth 25% of the business, the chances are the angel investor sitting in front of you will not take take your figures seriously without substantiation. Credibility is key and stating a reasonable yearly growth projection will place you in a position of strength especially when it comes down to your proposed sweat equity.
When calculating a reasonable sweat equity for yourself, please also take time to consider what type of industry you are in as choosing your industry will affect your chances of raising angel investment. Certain industries have garnered more attention than others over the past few years. The most interest has been in software, followed closely by healthcare, biotech, business products and services, consumer products and services, hardware and media and entertainment. Identifying the industry that you are in will help you get the most appropriate angel investors’ attention. At the very least, if your industry has significant growth future potential – this will maximise the chances of you asking for a higher percentage level of sweat equity on the initial cash investment that you have made into the business (plus anything else you have personally guaranteed).
If your business is not positioned in a growing industry, or perhaps you have not invested as much cash or personal time into your business during the early stages, then looking over how much Angel Investment Capital you actually need could save you a significant amount of equity in proportion to the angel investment you receive. It is very common for entrepreneurs to ask for more angel capital than they actually need to create a profitable business! So if you are asking for £50,000 angel investment, check how you intend to spend this. Creating a detailed excel spread sheet with your investment allocation can yield some very fruitful results! As an entrepreneur, it is your job to cut down the costs to a minimum when you are running a business – so you are obligated to do this when you are asking for investment!
So seriously consider your investment requirements. Can you cut it down to £35,000? Calculating the amount of angel funding that your business ACTUALLY requires is one of the most important steps in the process – too little and you are under-capitalised – too much and you could look profligate. The link above explores how to strike the optimal balance.