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Putting a Value on Sweat Equity

Summary:
For a company with shareholders, it’s straightforward to calculate the market value of the firm: just add up the cost of buying all the stock. For a company that is privately owned, calculating the market value is a lot harder. For a bare minimum value, one could add up the value of any physical or intellectual property assets the company owns. But many small private firms are worth a lot more than this minimum value. This additional value lies in the relationships that the company has built over time with supplier, customers, and the community. This extra value is sometimes called “sweat equity,” because it’s the value derived from the efforts of the owner. Jeff Horwich of the Minneapolis Federal Reserve provides a nice overview of some recent efforts to measure sweat equity in

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For a company with shareholders, it’s straightforward to calculate the market value of the firm: just add up the cost of buying all the stock. For a company that is privately owned, calculating the market value is a lot harder. For a bare minimum value, one could add up the value of any physical or intellectual property assets the company owns. But many small private firms are worth a lot more than this minimum value. This additional value lies in the relationships that the company has built over time with supplier, customers, and the community. This extra value is sometimes called “sweat equity,” because it’s the value derived from the efforts of the owner.

Jeff Horwich of the Minneapolis Federal Reserve provides a nice overview of some recent efforts to measure sweat equity in “From crêpes to Cargill: Hot on the trail of sweat equity: Fed economists pursue ever-better estimates of the invisible value beneath much of the U.S. economy” (January 3, 2022). Horwich is summarizing and putting in context a recent research paper by Anmol Bhandari and Ellen R. McGrattan “Sweat Equity in U.S. Private Business” which was published in the May 2021 issue of the Quarterly Journal of Economics (136: 2, pp. 727-781), but is freely available as a Minneapolis Fed “staff report.” The abstract of that research paper states:

We develop a theory of sweat equity—the value of business owners’ time and expenses to build customer bases, client lists, and other intangible assets. We … estimate a value for sweat equity in the private business sector equal to 1.2 times U.S. GDP, which is about the same magnitude as the value of fixed assets in use in these businesses. For a typical owner, 26 percent of the sweat equity is transferable through inheritance or sale. 

Horwich provides this background:

Private entities account for more than 60 percent of U.S. business income. Small businesses employ more than 60 million people—nearly four in 10 American workers. … The category of private companies includes some big names. With 155,000 employees around the world, family-owned Cargill is a notable example in the Minneapolis Fed’s district. However, 98 percent of private businesses in the United States have fewer than 20 employees; 96 percent have fewer than 10. …

The equity value of a public company is established by the research and daily decisions of millions of stock market investors: It is the value of all company shares outstanding. For private companies, however—a category that includes sole proprietorships, partnerships, S-corporations, and private C-corporations—we have limited public data and no market to work out what they add up to. … These invisible assets briefly appear when a private company is sold. Public records of the transaction provide a snapshot of the value of its various assets, as declared by the seller. Bhandari and McGrattan access data from the IRS and third-party-compiled records to determine that, for the median transaction, intangible components of equity comprise 64 percent of the price … Bhandari and McGrattan derive what they call a “proof-of-concept” estimate for the sweat equity of all U.S. private businesses: approximately 1.2 times U.S. GDP. This would amount to almost $28 trillion in late 2021.

Bhandari and McGrattan go beyond just looking at sales of private firms and also dig into income-tax data. The compensation that a business owner receives will be a return on both the physical assets and the sweat equity of the firm.

The importance of sweat equity raises a number of issues. First, sweat equity pretty much by definition involves the time of the business owner in one way or another. Thus, it may be that the key parameters in encouraging small businesses involve this investment of business owner time. For example, it may be that the key to how taxes or subsidies for small firms affect the firm is through how they affect the incentives of owners to invest hours. It may also be that any financial disincentives for small firms are no more important than the cost in time of following government rules and regulations.

Another issue is that sweat equity may be quite personal to the current business owner. Thus, even if a current owner is making a good living from a business, a potential buyer of the firm must worry that they can only buy the physical assets of the firm, and only a part of the detailed connections, knowledge, loyalties and reputation of the firm. An ongoing project for Bhandari and McGrattan is to study what factors can make sweat equity easier or harder to transfer to a buyer of the firm.

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