Question

There are two partners. One partner has invested a large amount of cash. The other has invested strictly time, which if fairly valued would also be a large amount of cash.

Is it reasonable, or acceptable to indicate the value of time invested in the form of a cash value as a “Startup Expense” Investment?

Answer

This issue is called “sweat equity,” and it comes up a lot.

Obviously, fairness is vital. Both partners should believe in the deal, and both should feel fairly treated. Both have to respect what the other partner contributed. Otherwise you’ve got a long-term disaster waiting to happen.

Whenever you can, you should always deal with these issues before contributions are made. Talk it out before anybody puts in either the time or the money. Both time and money are frequently worth more before they are spent than they are afterwards, when the spender can’t get them back. If either the time or the money is undervalued by either partner, then don’t go forward.

Photo by Gary Simmons

However it seems like in your case both time and money are already spent and now you’re negotiating a deal. Better now than later, always. You don’t want to start a company based on unfair ownership structure.

The best way to do it is the simple way, with shares of ownership. Talk it out between the partners. Decide what a fair recognition of sweat equity is, and give that partner a fair proportion of total ownership, which is usually a matter of stock. You don’t have to have millions of shares, I’ve seen companies started with 100 shares. Give fair shares to both partners.

You can invent fake money to tie into sweat equity, but there are problems you should be aware of:

1. When you put money into investment, standard financials assumes it’s there to spend. Sweat equity isn’t. Therefore, you have to balance that amount of money in the start-up table with the same amount of start-up expense. Specifically, if I put $50,000 into the start-up table as an investment value, based on sweat equity, then I have to put the same $50,000 into the start-up expenses as compensation. Otherwise I overstate my starting cash by $50,000. And double entry bookkeeping requires both entries. The one explains the other.
2. This fake money also increases the loss at start-up. So for example if the sweat equity value was $50,000, and the compensation of $50,000 means  the loss at start-up increases by $50,000 too. You can’t get around that, if it has a value, then that value is spent.
3. You might have to pay payroll taxes on this amount to make it fully legitimate. For this detail you need to consult an attorney or CPA, or both. We aren’t in a position to give professional advice of this kind on this forum, but this is a possibility. By the time you’re calling it an expense and a capital input, you should at least ask.

Business Plan Pro can handle this however you want to, the software doesn’t care, but you should be aware of some of these extra considerations.

And if you decide to handle this the simple way, with who owns how many shares of stock, the good news is that while that subject should be covered in text, it doesn’t affect the direct financials of the company. “Paid in capital” does, of course, and that’s what the investment input is. But who owns how many shares of stock doesn’t affect cash flow, income statement, or balance sheet, so it is dealt with in text only.

Tim Berry

Over on our Palo Alto Software Facebook page, Bernadette Njoku asked:

I’m looking for advice on what small businesses do/should do to build themselves financially over time, e.g., what are some recommendations on what to do if sales come in, should they reinvest into the business, what percentage, are there any ratios, are there recommendations, standard practices, or should we just wing it?

I showed the question to Tim Berry and this was his answer:

Bernadette,

Most of this is always on a case-by-case basis. There are a bunch of ratios that measure financial stability, most of them in the debt/equity category, but rules of thumb vary by industry.  And then there are the factors like your own sense of risk as an owner. I worked with one very famous entrepreneur who early-on in the company growth was constantly betting the whole company on a new product. He was a huge success, but eventually that high risk preference produced some big drops too. Although he’s worth billions right now.

The most reliable and conservative ratio is cash in the bank.

And then there’s the concept of a “good spend.” As a business owner, I’d rather spend on growing the company than on dividends or cash in the bank. I want the future, not just the present. So I always preferred a good spend to cash in the bank.

Lately a lot of investors talk about runway, as in how many months can you last at your current spending rate before you run out of money. That’s for startups that are spending in deficit, of course.

In the end, the best test is how it feels in your gut. Is this company “safe” or not? There are no general rules.

Tim

Thanks for the fantastic question, Bernadette!

‘Chelle Parmele
Social Media Marketing Manager

Fresh off of reading dozens of business plans for venture competitions, business planning expert (and competition judge) Tim Berry shares his insight on what entrepreneurs get right and wrong in their business plans.

Tim Berry’s new video talks about the basics for a good Elevator Pitch in this month’s video.

If you can’t view the video here, then check it out on our YouTube channel along with the rest of our business and marketing focused videos.

Palo Alto Software’s YouTube Videos

President and Founder of Palo Alto Software, Tim Berry has a weekly feature on www.bplans.com called “Ask Tim”.  In these weekly videos, Tim answers often asked questions that have been emailed to us or asked at the number of different conferences and lectures we attend all through the year.

In this particular video, Tim talks about how to start a sales forecast.

For more of Tim’s videos check out our business planning videos page or subscribe to our Palo Alto Software YouTube channel.

If you have a question for Tim, leave it in a comment here or email us at hello @ paloalto.com

‘Chelle Parmele