What it is:
Sweat equity is the time and effort that people contribute to a project.
How it works (Example):
Sweat equity is used to describe the non-financial investment that people contribute to the development of a project such as a start-up business. For example, sweat equity is counted from the founders of the company, as well as advisors and board members.
In many situations where some members of a partnership are contributing their money and others are spending time, the partnership may be composed of cash and non-cash (or sweat equity). Ultimately, sweat equity is rewarded the same as cash equity through a distribution of stock or other forms of equity in a start-up venture.
Sweat equity can also be considered literal. For example, a homeowner may spend time fixing, repairing, and renovating their home. The value of their efforts is considered sweat equity and adds to the value of the home.
Why it Matters:
Sweat equity is important to the successful start-up of a new venture, especially when cash is in short supply. However, it is important to value sweat equity carefully. In early stages, it is easy to overvalue it, offering stock in exchange for effort. However, over time, such trades can become very expensive and erode the equity available to follow-on investors. Sweat equity should be measured in terms of the long term value of the effort, the long term commitment of the participants, and the value-added by the participants to the overall goals of the venture.