# How to Calculate Sweat Equity?

Here is the scenario: I recently purchased some land for \$70,000 with the intention of developing a small resort. The plans and ideas are all mine and it is my intention to manage the project from construction to the actual day-to-day running of the resort. However, I needed an investor (venture capitalist) to bring the project to fruition. The investment amount required is around \$280,000. Now I have an investor who is willing to front this amount, but he is expecting the equity to be around 30-70 in his favour. My 30 includes his calculation of my ‘sweat’ equity along with my initial investment. This seems unrealistic for 1) surely my 100% involvement should relate to a fairly substantial ‘sweat’ equity and 2) at 70%, the investor is looking at a return of his investment within 4-5 years, after which he continues to receive 70% ad infinitum. I should mention that he does not intend to get involved in the project at all.
Is there a ‘fairer’ way to calculate the equity whereby he is well compensated for his initial investment but where it is not an open-ended return?
Any thoughts, ideas and suggestions would be appreciated.

 ArcSine Posts: 950, Reputation: 518 Senior Member #2 May 15, 2012, 05:23 AM
The answer to a situation like this is heavily fact-dependent; a specific answer isn't possible until the myriad underlying details have been examined under a bright light.

But very generally, the path to the answer follows some fundamental principles. It starts with a carefully-constructed set of forecasts and projections for the proposed project. Yeah, I know, crystal-ball work is (in places) guesswork at best. But you've still got to put a solid effort into developing revenue projections, asset cost estimates, expense budgets, etc.,

From the projections comes a rough idea of what kind of net cash flows the project is expected to generate. It'll likely be in the form of a range rather than a single estimate, and you might have the classic "optimistic, pessimistic, most likely" multi-scenario models. But however it shakes out, you end with some idea of how you see the net distributable cash flows playing out.

Next, do some research to determine what kind of return, or yield, financiers tend to expect on projects of similar risk, size and scope, and operating model. Then figure out what % of your project's net cash flows your investor would need to receive in order to realize an appropriate return. It might be 70%, or 60%, or 35%, or .... depending on the cash flow forecasts.

Simultaneously you have to evaluate it from your side of the table. What kind of return would you demand to invest \$70K in a similar project, and what kind of salary would you require in order to do the work (for someone else) that you plan on doing for this project?

Then finally, can the projected profits be allocated between the two of you in such a way that both of you are receiving a fair return: the investor's 70% (or 40% or whatever) meets the "required return" criterion I described above, and your 30% (or 60% or whatever) meets your required return criterion? If so, then a deal gets done. If not, you'll need to structure a different way to finance the deal.

Keep in mind that this is all very general stuff. A number of factors will play a hand, such as what kind of risk-protection devices you might build into the terms (investor having first priority on cash flows, collateral on certain assets, e.g.). An investor might accept a lower investment return if appropriate protective mechanisms are built into the deal, than he would otherwise without such safety nets underneath his investment.

Renting a professional advisor (say, an accountant with some expertise in deals of this nature) is usually money well spent (don't forget the tax planning and ramifications), and having an attorney help you build the agreements is de rigueur.

As a side note, this investor's desire to have a permanent 70% piece of the pie sounds unrealistic, absent some nonstandard circumstances. Expecting somebody to provide 100% of the labor and managerial services in exchange for such a dinky cut of the pie, in perpetuity, is delusional. Many private investors in such scenarios want a deal that operates similar to a bank loan (albeit an expensive one)---they receive X dollars for Y years, at which time they're paid off, having received an attractive overall return. If this guy wants a permanent piece of this action, he'll need to accept either: (1) a lower percentage share (say, after the first few "risky" years have successfully passed); or (2) you taking a large enough salary off the top, for your ongoing services, such that the remaining pie to be allocated 70 / 30 is a pretty small pie.

Best of luck with it!
 AdrianCavinder Posts: 40, Reputation: 10 Junior Member #3 May 15, 2012, 06:55 AM
Quote:
Fantastic! Thanks so much! That’s really helpful and put in terms that even I can understand. Cheers.

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