B.C. TRANSITION TOOLKIT FOR NON-FAMILY FARM TRANSFER – Stage 3
Sweat equity means that someone involved in the farm business is being paid below market rate in anticipation of a future return on their labour. Essentially, rather than investing money into the farm business, they are investing their time, energy, and “sweat.” The value of the farm business, and also the land, may be preserved or increased as a result (at least partially) of this person’s contribution.
Sweat equity often comes up in farm transition planning, especially when discussing the contributions of the entering farmer. Sweat equity can be a pathway to ownership for entering farmers who may not have the capital needed to purchase the farm and land outright, by trading unpaid labour for an ownership stake in the land and/or farm business.
DEVELOPING A SWEAT EQUITY AGREEMENT
Calculating sweat equity is complex and requires clarity, documentation, and discussion of expectations for both the entering farmer, current farmer, and any off-farm family heirs well before the transitioning process occurs.
Clear communication is key so that both parties understand the value of the entering farmer’s labour and how that will be compensated in the long-term. Having something in writing ensures that the sweat equity agreement is realized long-term, and protects against conflicts, failed businesses and broken relationships.
- Current farmers: have a clear understanding of your vision, and the financial needs of both your heirs and yourself before entering into a sweat equity agreement with an entering farmer.If there are off-farm children, what are their expectations around inheritance and returns from the farm? What have they already received as compensation for the sweat equity put into the farm during their youth (e.g. support with university, down-payment on housing, vehicles, etc.)?
- Entering farmers: have a clear understanding of the value of your labour, your financial needs short- and long-term, and the level of risk you can handle. There is inherent risk for the entering farmer; as with any investment, there is a chance that you won’t see a return on your ‘sweaty’ investment. On the other hand, investing labour now may enable you to gain hard equity later.
For sweat equity to work, all parties must have a clear understanding of the farm’s financial state. A good question to ask is: where would the farm be without the entering farmer’s unpaid labour? To understand the full value of the entering farmer’s contributions, it is essential to put a dollar amount on the value of the land and farm business at the start of a sweat equity agreement, and again at a later date, in order to evaluate the growth in value resulting from the entering farmer’s contributions.
While sweat equity can be a way for entering farmers to build an ownership stake in a farm business over time, it can also hide the fact that a farm is not as profitable as needed to support the entering farmer. If the farm’s value decreases instead of increasing, the entering farmer’s return on the sweat equity investment may be zero. Some transition plans opt to avoid sweat equity altogether by employing the entering farmer at market rate. Assuming the farm is profitable, being able to pay fair market wage demonstrates that there is capacity to add one or more additional farmers.
Sweat equity can be used as part of a purchase involving a cash down payment. Take the example of a young couple buying a farm in part with cash and in part with sweat equity. With a sweat equity purchase, the buyer is paying off all, or a portion of, the agreed cost of a property through labour. With start-up costs so high, it may be an essential way to transfer farms to the next generation.
Considerations for Sweat Equity Agreements:
- Vesting period: How long does the entering farmer have to work before being compensated? Vesting is a legal term that means to give or earn a right to a present or future payment, asset, or benefit, and your agreement should indicate at what point you can exercise your rights; for example, the entering farmer’s sweat equity may be “vested” when the land changes hands.
- What are the performance criteria and expectations around the contributions to the farm?
- Nature of the equity: What will the entering farmer receive in return for their sweat equity? Land ownership? Shares of the business?
- How will you assess the value of sweat equity? Based on a dollar value for hours worked, or on the difference in value of the farm business and land from the start of the sweat equity agreement to the vesting? What would you have paid someone of equal skill, ability, passion and commitment for the same work? Schedule conversations on compensation and expectations early on, and check-in regularly; consider hiring a facilitator.
- Exit strategies: Under what conditions can the agreement be dissolved? What if the entering farmer leaves the farm? Will they get some or all of the return on their sweat equity investment? What additional benefits has the farm provided to the entering farmer and off-farm heirs?
- Develop a framework for the discussion and boundaries so that everyone is comfortable with what is being proposed.
- Engage lawyers, accountants, mediators, families and business consultants in advance.