How do we measure the value of a private business? With 35 million of them—compared with just 6,000 publicly traded companies in the United States—that’s a vital question that remains surprisingly mysterious. 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.1 Understanding what makes them tick is vital for policies aimed at small business, innovation, and entrepreneurship—and for overall economic growth.
Fortunately, economists with the Minneapolis Fed are steadily improving our grasp of the intangible “sweat equity” that powers this huge part of our economy.
The hidden ingredients in that crêpe
Let’s set the table with an example. Amazing Crêpes in Whitefish, Mont., serves up sweet and savory options to locals, skiers, and visitors to nearby Glacier National Park. The business has some necessary physical items: crêpe billigs (aka griddles), tables, chairs, a food truck. There’s plenty of flour and sugar on hand at any given time.
But when Sara Seed bought Amazing Crêpes in 2018, that’s not primarily what she paid for. Seed estimates two-thirds of her purchase price covered things you can’t physically touch. She bought the well-honed batter recipes and hard-earned advice passed on by the founding owners. And, above all, Seed says, “It was mostly the brand: the brand-awareness, the reputation for quality, and the local connection.”
Sweat equity is a little like “dark matter” in physics: We can’t see it, but we’re confident it’s there and that it’s pretty darned important.
Want to know what that’s worth? Try surviving a pandemic as a small restaurant in a tourist town. “I really realized the value of that once COVID hit,” Seed says. “We had this community of people locally and people who travel here year after year who were really invested in seeing us succeed.” That valuable reservoir of goodwill kept this crêpe shop afloat.
All this intangible value represents the “sweat equity” built up by the prior owners. And now that she’s running the place, Seed is adding her own every day.
Out of sight, but not out of mind
For Minneapolis Fed consultant and University of Minnesota economist Ellen McGrattan, sweat equity has long felt a little like “dark matter” in physics: We can’t see it, but we’re confident it’s there and that it’s pretty darned important.
The concept of sweat equity was central to McGrattan’s work with Nobel Laureate Ed Prescott to deconstruct the 1990s tech boom. But measuring it with confidence “was a nut that we were never able to crack,” McGrattan says. “We wanted to get at intangibles in private business, but we didn’t have a good idea of how to look at them.”
McGrattan was frustrated to see research on entrepreneurship pretending that intangible equity didn’t exist. “We felt that was a big hole in the literature, that people were writing down models that were not at all matching the data we were seeing.”
Today, richer data and a refined theory have reinvigorated the pursuit of sweat equity for McGrattan and fellow University of Minnesota economist (and Minneapolis Fed visiting scholar) Anmol Bhandari.
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.
Like our Montana crêpery, these businesses have some capital that is physical (or “fixed”) and a whole bunch that is not. This includes any labor by owners for which they do not pay themselves a wage—the intuitive concept of sweat equity that probably comes to mind for most of us. But it also includes name recognition, reputation and goodwill, the owner’s knowledge and skills, and networks of business and customer contacts.
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 (uncannily close to Seed’s rough estimate of two-thirds when she bought the crêpe business).
The economists label this measure “intangible intensity.” The accompanying figure shows the readings across different industries, from a high of 86 percent in finance and insurance to a low of 42 percent in accommodation and food.
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Unfortunately for the researchers, most businesses aren’t sold very often. So to estimate the sweat equity value of these millions of going concerns, they combine economic theory with ever-more-detailed tax data.
Bhandari likens it to deriving the value of a mutual fund. “You know the profits of a business, you know how long the business is going to last. And you know, roughly speaking, how much of that profit is compensation for the owner’s time,” he says. “If you have these three pieces, you can back out what is the return you’re getting on your sweat capital. The present value of that is the valuation.”
In their latest Minneapolis Fed staff report and the May 2021 Quarterly Journal of Economics, 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 2021.2
McGrattan says the scale of their working estimate “should give people a gut check. When they think about small businesses, a lot of people don’t realize how much of the income in the national accounts is going to them.”
As large as this number seems, “it sounds too little to me,” says Bhandari. The economists believe a larger, more precise value will emerge as they access more IRS data to better isolate the unpaid time of business owners.
Still, the scale of the current estimate “should give people a gut check,” says McGrattan. “When they think about small businesses, a lot of people don’t realize how much of the income in the national accounts is going to them. They think they’re trivial.”
Getting small business policy right
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 10.3
You’ve likely heard this well-worn political talking point: Small businesses create the majority of new jobs. (This is arguably true, though it depends on how you slice the data.4) There are few stances more universally popular than supporting American small business. Yet if we underestimate the role of sweat equity—and the sheer amount of it out there—we could be hindering this policy goal.
Bhandari and McGrattan’s assessment of sweat equity shows how fundamentally the value of a business depends upon the incentives of the owner. Tweaking the dials on taxes or regulation can have significant effects on whether owners start or buy a business, and on how much sweat they put in to help it succeed. In their model, the economists find that a 1 percentage point decrease in the private business tax rate would lead (in the first year) to a 0.4 percentage point increase in new businesses and a 0.3 percentage point increase in owner hours.
The model results align with surveys of small business owners that suggest policy is overly focused on access to credit and credit subsidies.5 Instead, Bhandari says, what owners really need is time—supported by low taxes and freedom from red tape. “You only have 24 hours in a day. Our view is that they’ll grow slowly because it does take time to find new clients and build sweat capital. It has nothing to do with the fact that they couldn’t qualify for a loan.”
The importance—and challenge—of transferring sweat equity
In a thriving small business environment, it would be easy for a business to change hands. McGrattan’s sense it that this is not as easy as it should be, and that the challenge of transferring intangible equity has something to do with it.
Tweaking the dials on taxes or regulation can have significant effects on whether owners start a business and how much sweat they put in to help it succeed.
“We’re not seeing lots of sales,” McGrattan says. “And one question is, do we have misallocation of capital because it’s difficult to transfer these businesses?”
Policy could help, but we would first want to understand how much sweat equity is transferrable and of what types. The economists plan to use artificial intelligence to comb through mountains of written notes from sales transactions to understand the process of one owner conveying these intangible elements to a successor.
At Amazing Crêpes, Seed and the two founding owners invested heavily in the sweat equity handoff. For months leading up to the sale, Seed worked behind the counter as an employee. They spent hours together reviewing the financials and the business history. “We talked about how they developed the recipes, why certain things were on the menu, why some weren’t,” Seed says. To preserve loyalty and community goodwill, they set up meetings with longtime customers to introduce Seed as the new owner.
The founders have remained just a phone call away. One jumped back on the production line during the first tourist rush.
“I was able to see in real time how to scale up and move so much faster, especially in the summer season,” Seed says. “It’s one thing to talk about it when it’s slow. It’s quite another to have a line 20 people deep!”
For Seed and the founders, it all helped preserve the underlying sweat-equity value of the business—unseen, but indispensable.