What is equity in a business?

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, it 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 to know all about the shareholder equity in a business.

Key Points about Equity

• Equity represents the net worth or value of a business that would be returned to the owners/shareholders if all assets were liquidated and liabilities paid off.
• It is an important indicator of a company’s financial health and stability. Positive and increasing signifies the prospering.
• Companies can raise equity financing by selling ownership stakes to investors in exchange for capital, rather than taking on debt.
• Formula: Equity = Total Assets – Total Liabilities

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 company assets 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 company assets are the items that have value in the business, including the patents, trademarks, inventory, or property. The company 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.

What is share capital in Equity?

Share capital is made up of the equity owners have put into the company by purchasing shares. It is also treated as one of the permanent sources of funds for the company.

The main types of share capital are:

• Common stock
• Preferred Stock

Along with this share capital plays a critical role in a firm’s financial health and operational capacity, not just this together with share capital influence companies ability to raise funds, invest in growth and face risks.

Features of Equity

Equity financing provides companies with an alternative to debt financing in order to raise capital.

Here is a table summarizing the key features of equity in a business:

Types of Equity

The main types of stock include common stock, preferred stock, treasury stock, additional paid-in capital, and retained earnings. Each type has unique characteristics regarding ownership rights, dividends, voting power, and claims on assets.

How do you calculate business equity?

For calculating small business equity, use the simple accounting equation:

Once you calculate, 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 company assets or liabilities by rearranging the formula as:

The share price is an important metric for investors reflecting the market’s valuation of a company’s equity. Share price is also needed for calculating the market value and is subject to various influences.

Shareholder 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.

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.

Company shareholder equity 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 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 total company’s assets on the balance sheet for the period.
• Add all the liabilities, which can be found on a separate listing on the balance sheet.
• Locate the total SE and add the number to the total liabilities.
• Total company 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 owned by the company.

By comparing the number of everything that 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.

Equity is crucial as it represents the value of the stake of the investor, which is represented by their proportion of the share capital. The company offers shareholders the right to through stocks, which gives them the potential for dividends and capital gains. Owning this 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.

But it should be kept in mind that it is not 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

We will be taking both the positive and negative examples to explain it further.

Positive equity example

Let’s assume that you have a cloth manufacturing firm, 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 liabilities increase to $20,000, and the assets remain at $15,000. In this case:

Equity = $15,000 – 20,000 = $-5,000

In short, it will reduce to a negative amount of $5,000.

Example of setting a goal

Following the last situation where the liabilities are $15,000 and you want to reach a 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 company assets and $15,000 in liabilities.

The market capitalization is calculated by multiplying the current share price by the total number of outstanding shares. For example, if a firm has a share price of $50 and 1 million outstanding shares, its market capitalization would be $50 million.

Equity Financing

It is normal for people to confuse debt funding and equity funding as it also involves funds. Nevertheless, equity funding is when money is obtained from investors 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 this 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 firm ends up failing, you do not have to pay anything back 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 in detail:

Advantages

• 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 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

• As compared to the time period of getting debt funding, getting equity financing for startups takes longer.
• For obtaining 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 funding.

FAQs

Here are some frequently asked questions about equity in business:

Can a Company Raise Equity?

Yes, by selling ownership stakes (issuing new shares) to investors in exchange for capital that avoids taking on debt.

What are the Benefits of Equity For Investors?

Investors become part-owners with voting rights and can benefit from capital appreciation if the company’s value increases, as well as dividends from profits.

What are the Risks of Equity Investing?

Higher risk compared to debt. Returns are not guaranteed – investors can lose their entire investment if the company fails.

What is the Difference Between Debt Financing and Equity?

Equity represents ownership while debt is borrowed capital that must be repaid with interest. Investors take on more risk but can benefit from the company’s success.

Manage Your Company Equity using Eqvista

When you are giving out equity to investors and growing the company, you will need to keep a track of all of your 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.

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.