What is equity in a business?
Here is everything you need to know about equity in a business and what equity financing for startups is.
In the world of finance, equity is one of the most important things that define a company. Equity in business means the value of ownership. Basically, equity can be utilized to measure the company’s overall value, the inventory owned, a single stock, or any other thing that has value in the company. It is vital for every founder and company owner to know all about the shareholder equity in a business.
Equity in Business
Business equity is the value of the assets less liabilities in your business. Being a business owner, you have the rights to all the things in the company that have value. And along with this, you take the responsibilities of your liabilities too. In short, you can easily measure the equity in the business by looking at the relationship between the liabilities and assets in the business.
To elaborate more, your assets are the items that have value in the business, including the patents, trademarks, inventory, or property. The assets can be both tangible and intangible. Tangible assets are the physical things that you can touch, such as a building, while intangible assets are the ones you cannot touch, like copyrights and other intellectual property.
Liabilities are the debt in your business. It is the debt your company owes to any agency, vendor, employee, organization, or any other business. It is normal to incur debt through regular business operations. As the equity in a business is the relationship between the assets and liabilities, the more liabilities in the business, the lesser the equity.
How do you calculate business equity?
For calculating small business equity, use the simple accounting equation:
Once you calculate your equity, you will have to report this amount on your balance sheet. This formula can also be used to identify the amount you need to have in liabilities or assets to reach an equity goal. Additionally, this accounting equation can help you determine the total assets or liabilities by rearranging the formula as:
Assets = Liabilities + Equity
Assets = Liabilities + Equity
For corporations, the shareholder equity (SE), which is also called stockholders’ equity, is the corporation’s owners’ residual claim on the assets after the debt has been paid. As mentioned above, the equity in a business is the total assets minus the total liabilities in the company. But the shareholder equity is part of the equity that the shareholder owns in the company.
Retained earnings are a part of shareholder equity, and is the percentage of the total earnings that were not paid to the shareholders as dividends. And the retained earnings are not cash or other liquid assets. This is because years of retained earnings are then used for other things that can help grow the business and increase its value. Shareholder equity for a company that is a going concern isn’t the same as the liquidation value. In liquidation, physical asset values have been reduced and other extraordinary conditions exist.
Shareholder Equity Formula
The shareholder equity formula is:
This formula is also known as the balance sheet equation or the accounting equation. The balance sheet holds the basis of the accounting equation.
Here are the steps to calculate the SE:
- Locate the company’s total assets on the balance sheet for the period.
- Add all the liabilities in the company, which can be found on a separate listing on the balance sheet.
- Locate the total shareholder’s equity and add the number to the total liabilities.
- Total assets will be equal to the sum of the liabilities and the total equity.
For a few things, such as the earnings per share and dividends, a more relevant measure is used, as shares “issued and outstanding”. This measure excludes Treasury Shares, which are the shares owned by the company.
By comparing the number of everything that the company owns and owes, the shareholder equity formula paints a clear picture of the finances of the company. This can then be easily interpreted by different investors and analysts. The equity of the business is used as capital raised by the company, which is then used to fund operations, invest in projects, and purchase assets. A company can easily raise capital by issuing debt with bonds or through equity, which is done by selling stock. It is common for investors to invest in equity investments, as it offers them more opportunities to get a share of the profits in the company as it grows.
Equity is crucial as it represents the value of the stake of the investor in the company, which is represented by their proportion of the company’s shares. The company offers shareholders the right to own equity through stocks, which gives them the potential for dividends and capital gains. Owning equity would also offer the shareholders the right to vote in any important corporate decisions and for the election of the board members in the corporation. All these benefits that come with shareholder equity ownership keep the ongoing interest of the shareholder in the company.
But it should be kept in mind that shareholder equity isn’t the only factor that defines the financial health of the company. So investors would also look into other things and use tools to determine if they should invest in the business or not.
Example of using the Shareholder Equity Formula
Here is how to calculate shareholder equity. Just note that we will be taking both the positive and negative examples to explain it further.
Positive equity example
Let’s assume that you have a clothing company, and your cash, inventory, and all other assets have a total value of $15,000. On the other hand, your debt and liabilities of your company total $6,000.
Equity = $15,000 – 6,000 = $9,000
This means that you have a $9,000 worth of equity in your business.
Negative equity example
Now let us assume that your company’s liabilities increase to $20,000, and the assets remain at $15,000. In this case:
Equity = $15,000 – 20,000 = $-5,000
In short, your equity will reduce to a negative amount of $5,000.
Example of setting an Equity goal
Following the last situation where the liabilities are $15,000 and you want to reach an equity goal of $35,000 for your business. To find the number of assets you need for you to meet your goal, you will need to reverse engineer the formula and use:
Assets = Liabilities + Equity = $15,000 + 35,000 = $50,000
This means that for you to reach the goal of $35,000 of equity in your business, you will need to have about $50,000 in assets and $15,000 in liabilities.
It is normal for people to confuse debt funding and equity funding as equity funding also involves funds. Nevertheless, equity funding is when money is obtained from investors in a company in exchange for company shares. These investors are not ones like your friends, family, or other small investors. They are usually from big investors like venture capitalists and angel investors.
The best thing about equity financing for startups is that it is the investors who are taking the risk. And with them giving you funding, you will have enough to grow your business without worrying about interest payments that come with bank loans (debt financing). This also means that if your company ends up failing, you do not have to pay anything back to the investor. Although everything is great for the founders when getting equity financing for their startups, there are downsides to it too. To get funding, a part of the company has to be given to the investor.
What are the advantages and disadvantages of equity financing?
With the above information covered, let’s now talk about the various advantages and disadvantages of equity financing in detail:
Advantages of Equity Financing in Startups
- If the company fails, you would not have to pay any money to the investors for what they invested in the business.
- Getting in contact with the right investors, you would be able to connect with various other professionals in the industry through them. This would allow you to gain more wisdom, great experience, and many other things. These relationships would help you a lot in growing your business and expanding it.
- Unlike debt funding, you would not have to pay any interest for the equity funding that you get. This would mean that you will be spending all the profits you get for growing your company and not for loan repayments. It offers the chance to focus on developing your business.
Disadvantages of Equity Financing in Startups
- As compared to the time period of getting debt funding, getting equity financing for startups takes longer.
- For obtaining equity funding, you will be giving out ownership of the businesses. This also would mean that you are giving the decision-making power to them. And for this, you will again spend money to get a lawyer involved and make the right decision for company funding.
Manage Your Company Equity using Eqvista
With all this, you now know what equity in a business is. But when you are giving out equity to investors and growing the company, you will need to keep a track of all of your company shares. The only way you can do it is by using a cap table. Eqvista is a FREE and advanced cap table software that allows you to keep track and manage all the shareholder equity in your company.
Not only this; you can also issue all the shares online, add shareholders, use tools like the round modeling and waterfall analysis to see how company ownership is being diluted with every funding round.