As long as it is approved by LLC members, a new member can join the LLC via sweat equity. Sweat equity is a non-monetary contribution to an LLC.

Use Sweat Equity To Add Partners To Your LLC

Some business owners add a partner to their company by using sweat equity. However, this approach is good only for certain circumstances.

Sweat Equity Explained

In many startup situations, sometimes compensation takes the form of ownership in a piece of the company in lieu of a monetary payment. This is sweat equity. This is especially true if the startup does not have enough cash to pay its employees, partners, or consultants. If the payor and payee agree to it, sweat equity can pay for any services received, any advice received, any labor hours worked by employees, and any contributions to the business.

An Example To Illustrate Sweat Equity

Let’s say a startup company required expertise in marketing. However, because it is just starting out, it does not have enough funds to pay the salary that a seasoned marketing professional would expect. However, the young company can offer a stake in the company as payment for services. This arrangement is win-win because the company will get professional marketing talent without going into debt, and the person hired will own part of the company. If the company becomes successful, the equity will be worth a lot more.

How To Calculate Sweat Equity

There are different ways of calculating sweat equity. Whatever way is chosen, the company must use that as a standard for valuating any sweat equity offered. One way is to figure out how much that employee would make in a similar job at another place. Another way is to figure out how much you would have to pay if you hired another person. A third approach is to estimate how much value the employee added to the company by working there. If desired, these methods can be combined.

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How Does Sweat Equity Play Into Your Operating Agreement

If you plan to offer sweat equity in your LLC, you must address these and other issues in your operating agreement. An LLC provides voting rights, profit sharing, ownership stakes, and other rights to people who have equity. However, you have to decide how the holders of sweat equity in your company are treated and the method in which profits are distributed. You have to determine how you should calculate sweat equity. All this should be done early to avoid future disagreements.

How To Create An Agreement for Sweat Equity

When you have described the particulars in the operating agreement, you are ready to create a sweat equity agreement. It is advisable to create this written agreement early. One of the biggest problems in startups is that agreements are often made verbally or with just a handshake. This is very risky because if a conflict arises, it will be very difficult to go back to a verbal agreement that is vague and up to interpretation. Having this agreement clearly written out in detail, describing what employees or contributors are expected to do and how much they will be compensated in sweat equity for their contribution, will prevent any misunderstanding. Here are some things to include in your agreement:

– Equity Type: What kind of equity will the employee get, and how much is he getting?
– State the Criteria of the Performance: What does the employee have to do in return for sweat equity?
– Provisions for Separation: Who and when can this agreement be broken? If the employee leaves the company, what’s to be done about the employee’s equity?

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Can Sweat Equity Be Taxed?

Sweat equity is considered taxable income. In the sweat equity agreement, the company and the person receiving sweat equity have to pay taxes based on how the equity is valuated. For instance, if a sweat equity agreement states that the consultant’s fee in sweat equity is valued at $100,000, then taxes need to be paid on $100,000.

Tips On Reducing Tax Liability of Sweat Equity

Sweat equity is not cash, but it is taxed like a cash income. That is a disadvantage to those who are paid in sweat equity because they cannot use a portion of their payment to cover taxes.

One possible approach to lowering the tax liability of sweat equity is to pay the sweat equity close to the company’s formation. Paying in sweat equity before you issue equity to investors and venture capitalists will enable the employee to get sweat equity payment before the valuation goes up, which will lower the taxable value.

Another approach in reducing the tax liability is to offer shares in future profits rather than conventional equity in the business. Using this method will not result in any current value and will not produce any taxable income.

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Should I Add A Business Partner via Sweat Equity?

Using sweat equity to add a business partner can be useful for some businesses, but not all. Here are some advantages and disadvantages for your consideration:

Advantages of Sweat Equity

Conserves cash: Young companies are typically low on cash, so they have to keep their expenses down. By paying in sweat equity, you can reduce expenses as you grow your company.

A magnet for talent: Offering to pay in sweat equity can lure talented people to work for your company whom you cannot afford to pay otherwise. This is a good way to hire the talent you need to build your business.

Effective incentive: Because equity is worth more when the value of the company grows, people who are paid in sweat equity would be motivated to work harder to make the company successful.

Disadvantages of Sweat Equity

Hard to determine value: Value is subjective, so it is hard to have everyone agree on how sweat equity can be valuated. Should you look at the average salary that a person can earn doing a similar job? Does the work done for the company add comparable value to the company? The worth of sweat equity is what the company says it’s worth.

Can result in disagreements: Because figuring out the value of sweat equity is so ambiguous, it can end up with people arguing over it. Staff might feel that what they have contributed is worth more than what the company says their equity is worth. This can result in conflicts that can adversely affect the morale of the business.