Mailbag: Sweat vs. Skin

mailbag.gifWhat is better? Sweat equity or having “skin in the game?” How much of an investment do you need to be considered as having “skin in the game?” Inquiring minds want to know. I received the following email from a technology entrepreneur building his business:

Just read your “Down to the Mat” article, and wow, you really open the kimono as the VCs would say – I take it you’re not looking for angel funding? ;). Good stuff though. What’s your thought on time spent developing the product? I’m putting in the time writing my software product but have maybe $400 invested and feel that I have “skin in the game”. I fear this question because I have to answer “I don’t have any money to invest at this point but look at the shiney software!”

Glad to hear you enjoyed the aforementioned post. For the record, we are currently seeking a Series-A financing, just not from the type of investor who considers personal insolvency as some sort of entrepreneurial golden seal of approval. :) On to your question …

The situation you describe is not uncommon, especially in the technology and internet sectors. Let’s break it down:

Assuming you are sitting at the table with potential investors, they are going to dig into the balance sheet of your business and are going to zero in on a couple of things.

1) The tangibles: what are the assets of the business (including cash)?

2) The intangibles: what reasonable sweat equity does the entrepreneur have in the business? What is value of the intellectual property (IP)?

The tangibles are easy to determine. Anything “owned” by the business is considered an asset. This includes equipment, and paid-in capital contributed by the founders. Again, fairly easy to determine. If the business has 10K in the bank, and 20K in equipment, then the assets of the business are at least worth 30K.

The “intangibles” are where the angst usually lies. The same dynamic that lies in the valuation process rears its ugly head here as well. The entrepreneur generally feels like the sweat equity they’ve earned is far and above what the investors are willing to live with. And vice versa.

So how do you measure sweat equity? it is very subjective, obviously.

First, do what you can do increase the value of your tangible assets. If you can increase the value of the tangible, the value of the intangibles are going to go up with it. There is a positive correlation there.

If you have cash to put into the business, do it. Also, examine your other expenses. You say you have $400 in your business. More than likely, that is too low of a number to be considered “serious skin” in the game. There is no set figure here, but $400 is certainly going to be on the low end. It is really relative to what it is that you are doing in the first place. What is the percentage of your cash investment against the perceived value of what it is that you’ve built?

Your figure of $400 is not a lot, however, I’m willing to bet that your actual number is probably higher than that. If you bought a laptop, and you are doing your development work on that computer, guess what? There’s $2-3K right there. Other things to consider: cell phone bills, office supplies, lunches, coffees, parking fees, tolls, software/scripts, books, training/education costs, ISP and hosting fees, etc. All of these things are legitimate expenses when building a business, and the good news is that investors realize this. Leave no stone unturned.

Next, take a hard look at what you’ve personally put into the business from a non-cash basis. However, keep in mind that there is not a one-to-one correlation here. This is one of the traps that many entrepreneurs fall into.

For example, let’s say you’ve spent 20 hours a week for a year working on your product. That comes to about 1,000 manhours of effort. Logic would dictate that you would multiply those hours by some “reasonable” bill rate (e.g. $100/hour), and decide that you now have 1,000 x $100 worth of sweat equity in the business (in this case, $100K). However, it doesn’t work that way in reality. Certainly, if you were to have paid someone to do that work, then that represents “cash saved.”

And this brings me to my final, and most important point.

You have to consider the *real* value of what it is you’ve built, in conjunction with the amount of time/effort you’ve personally put into your business. Perhaps it took you 20 hours every week for a year, but in the eyes of another person, what you’ve built could have been done in half the time by someone else. Perhaps what you’ve built isn’t really “unique” enough. Perhaps investors don’t see “100K worth of value” in what you’ve built. In these cases, the value goes down.

On the other hand, if what you’ve built has “value” in the eyes of the investor, then your sweat equity is worth more. If you have users, paying or otherwise, then things are going to be headed in the right direction on the scale. If you are fortunate enough to have paying customers, then you have more leverage. It gets a hell of a lot easier to defend your sweat equity when the dogs are eating your dog food, as it were.

Focus on providing a defensible basis for the value of your product/service. If the investors sniff value in what you’re doing, you will come out ahead in the long run. How big is your market? Do you have beta users? Paying customers? Do you have a competetive edge? Can the investors reasonably expect a 7-10X return?
Each investor is going to have their own values, opinions, and threshholds. The trick is to go in with a balanced and honest view of what you have in the business, and what you are looking to get out of it. Sweat equity isn’t a requirement, just a nicety. At the end of the day what matters most is value to the customer.

Of course, there exists the possibility that you don’t even need outside capital to get your business to the next level. If you have developed a prototype product, get some early users on it and see what feedback you get. You just never know … things could take off, and the next thing you know, you’re paying your bills.


1 Comment

  1. Mike Blake ยท January 10, 2007 at 2:07 pm

    This is a neat post. Wish I had read it before now. A comment I’d like to add is that sweat and skin actually have fundamentally different kinds of value.

    The “sweat” value can be valued. Sometimes it’s called “personal goodwill” among us finance types. You could, as Scott suggests, use a proxy billing rate. Or you could set a value on the intellectual property (challenging but doable). When it boils down, “sweat” is really the opportunity to succeed. The value of “sweat” is basically how much of the company you have left after it receives capital.

    “Skin” is fundamentally different. Whereas Sweat builds value, Skin moderates risk. “Skin” says you won’t just walk away when things get tough or you get an unexpected lucrative job offer.

    To illustrate: I believe that a fundamental cause of the dot-com crash was the lack of Skin in the industry relative to Sweat and Cash. The 20-somethings were bummed out when their businesses went under, but did they really lose anything? Might they have worked harder and smarter if they had their own assets on the line?

    To sum up: Sweat is value creation. Skin is value protection.

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