Sweat equity means labor or services performed by a shareholder that adds value one way or another to the corporation, as opposed to a strict amount of financial capital contributed into the business. This informal term is a way of describing the contributions of time and effort by the founders and early employees of a small business, such as an S corporation.
In the context of an S corporation, sweat equity represents the value of a particular shareholder's capital contribution and relative ownership interest in a corporation when it is formed. For example, if the S corporation has three shareholders, two might invest cash in the business while the third agrees to contribute his services to the new corporation. If everyone agrees as to the value of the services, the relative ownership stakes can be assigned up front.
The shareholders can assign a fixed value on the sweat equity at the startup phase and decide how much ownership interest the owner should get in exchange for his services up front. However, once the shares of stock that represent each shareholder's ownership interest are distributed, the valuation of the sweat equity contribution is fixed and cannot be changed later. For example, if it is decided that an owner gets 33 percent of the outstanding stock in exchange for his work done for the company, that share allocation can't be changed retroactively, even if the shareholder provides inadequate services or stops doing work for the company prematurely. To avoid these types of issues, rather than value all sweat equity up front, a better way to value ongoing labor contributions is by assigning a reasonable hourly rate to the shareholder's time working on the company's behalf. This means his ownership stake will increase over time as he makes his contribution to the company, and it prevents common disputes from arising regarding the quality or extent of services rendered.
An S corporation is designated by the IRS as a small business corporation with relatively few shareholders. Accordingly, with a smaller number of owners, each individual shareholder owns a relatively greater share of the company. Thus, any unresolved disputes about money, ownership or management issues between shareholders in this common small business situation can have serious adverse consequences because of their individual power and relative level of control of the business. So, it should be a high priority for all shareholders to avoid these types of disputes by carefully agreeing in advance on how to value sweat equity.