Gary Stern

In September 2008, when partners Paul Rosenfeld and Tracy Grover were launching Fanminder, a text message marketing company that’s trying to appeal to six million small businesses, they didn’t even consider going to a bank for start-up capital. Rosenfeld quipped that the definition of a banker is someone who gives you an umbrella and then takes it back when it rains.

Instead of seeking capital, Fanminder, based in Mountain View, California, took two routes to launching: starting in a home office with minimal capital and then seeking to build staff through sweat equity, giving employees a slight stake of 0.1% to 0.5% ownership each, amounting to about 5% total for 25 employees.

Both partners resigned from Account Now, where Rosenfeld was head of marketing and Grover was head of products, because they thought their business model had a competitive edge and would find an audience. While Walmart (WMT) and Sears (SHLD) have used text messaging to offer promotions and entice repeat businesses, most small businesses didn’t have the resources to maintain e-mail lists, write newsletters, and oversee marketing.

"We were at the same point with text messaging that websites were in 1997," Rosenfeld noted, adding that 77% of Americans send texts.

Raising less than $50,000 from friends and family and relying on savings, they started from home, didn’t have to buy equipment, and wanted to see if there was a market for their business. However, they needed engineers to create software, designers to build the site, and sales and marketing staff to identify customers but didn’t have the capital to pay them.

Tapping their network, the partners identified 25 people who agreed to work part-time for about 10 to 15 hours a week, usually at night, for one year without salary for miniscule ownership rights. Of course, Rosenfeld noted that dreamers can contemplate that a 1% ownership stake of a company that sells for $200 million is worth $2 million.

Ironically, most staff were working at large companies and wanted to make the most of their talents, were stay-at-home moms, or were between jobs and seeking full-time employment, rather than dreaming about making a million (or a quarter of a million) if the company ever took off.

After going live in September 2009, Fanminder has secured about 30 customers and is beginning to show signs of identifying a market.

Angel investors want to see four criteria, "a team in place, product launch, proof that the concept works, and customers," Rosenfeld said. Because Fanminder has all four elements, its partners are seeking a $1 million dollar investment from angels to grow the business, rent an office, and hire and pay full-time staff.  Trying to obtain start-up capital forces most new ventures into a Catch-22 situation, explained Glenn Kaplus, an adjunct lecturer on entrepreneurship at Babson College in Wellesley Hills, Massachusetts, who also runs an eponymous consulting company. Increasingly, banks want to see a proven track record of success before loaning money, which, of course, start-ups can’t provide. (See also The Real Reason Small Business Loans Are Gone)

"We’re in a great reset. What used to be easy money and easy access to profitability are gone," Kaplus said. Banks and angel investors are scrutinizing business models, assuming less risk, and aren’t investing unless they see a clear chance of returns.

Kaplus sees an advantage and trap when entrepreneurs turn to sweat. The clear benefit is getting 20 people to work on your business for deferred payment, which enables many start-ups to debut with minimal investment.

However, owners who relinquish too much sweat equity can yield control and decision-making, and that can doom a business. The team of owners usually demands a say in the business and often disagrees with the original entrepreneur’s strategy, which can lead to undermining decision-making and the business’ original vision. Entrepreneurs who maintain 51% or more control continue to call the shots.

In the long run, owners who opt for sweat equity run the risk of paying more than if they maintained paid salaries, Kaplus noted. If an entrepreneur offers 10% of ownership and the company is worth a million dollars, that’s $100,000 rather than paying $50,000 in salary. That explains why the Fanminder partners relinquished only 5% ownership to its employees.

Though sweat equity is employed in many Internet and IT start-ups, it can apply to any business. For example, a real-estate entrepreneur buys a rundown property that needs renovation, offers sweat equity, not salary, to an electrician, carpenter, framer, and contractor who get paid when the building is sold. Often they’re paid more for delaying salary but everything is negotiable.

Launching with sweat equity rather than start-up capital buys time and gives a business a chance to succeed. If the start-up shows steady income and a competitive edge, venture capitalists, banks, and angel investors will soon come knocking on the entrepreneur’s door.

©2008 Minyanville Publishing and Multimedia, LLC. All Rights Reserved.

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