Types of Equity

In business terms, equity means the value of ownership in something, most often equity in a business. Basically, equity can be used to measure the value of a whole business, a single share, and any other thing that has value in a company. In fact, there isn’t just one kind of equity, but several different forms of shares in a company. The different types of equity are used to attract different investors with funds of all sizes.

To understand what the different types of equity are, let’s first understand what equity in a business is.

Equity

Equity in a business is the ownership an investor has in a corporation, which is also called their company shares. The income of the corporation is divided into shares, after the company has fulfilled and paid all its other financial obligations and debt. The price of the shares or equity is based on different factors based on the income of the business. This price is the value determined for a share by looking into the earning potential of the company.

The factors that determine the earning potential of a company include:

• State of the economy in the specific industry of the corporation
• State of the economy on the international and national levels, based on the size and reach of the company
• Financial ratio analysis
• Development stage
• Projected growth
• Projected earnings

How does equity work?

Equity in business always represents some kind of business value, but it has many different uses. The following applications of the term would help you understand better. You will also notice that the end concept of how equity works is that equity in a business is the sum of the net earnings, assets, and inventory.

Stock

Equity can be referred to as the ownership interest in the company as represented by stock or securities. In short, investors can own equity shares in the company in the form of preferred or common stock. This means that the original company owner would be sharing their ownership with others, who would be known as shareholders. Equity given to the shareholders would be represented as the cash value they would get for those shares, if they are going to sell.

Due to market forces, this price fluctuates over time. An investor can get their total stake in the business by multiplying the value of one share with the total stock they have. In case a trader engages in margin trading where they borrow money to purchase stock, then the equity of the trader would be the value of the securities they get minus what they borrowed.

Balance Sheet

When you look at the balance sheet of a company, you will see the total equity in the business mentioned. This is the sum of the retained earnings, paid-in capital, preferred stock, and common stock. And it is known as the stockholders’ equity or shareholder equity as it represents the total equity shared by all the company’s owners.

Real Estate

Equity is also used in real estate, which is the difference between the fair market value of the property and the balance owed on the mortgage.

Liquidation

The last way of how equity in a business works is when your business goes bankrupt and you have to liquidate your company, the ownership equity is the amount of money left in the company after the creditors are paid and the assets of the company have been sold. Usually, there is no ownership equity left once all the debt has been repaid in cases the company has gone bankrupt.

Equity Examples

Let us now look into some examples to understand this concept better. Consider two simplified hypothetical situations:

Assuming you want to sell your business and you rent out your workplace, but you do not own the needed $15,000 worth of equipment. And you only have savings of $10,000 that you can add to the business. So, you get a loan of $5,000 to add it to what you have and get the needed equipment. Because of this loan, you now owe $5,000. This means that you have a $10,000 worth of equity in your business.

Taking another example, let us assume that you need to get more loans to keep the business afloat. Now, if you get another loan worth $10,000, it would mean that you owe $15,000, indicating negative equity. You can even sell all your assets and you will still not be able to cover your total debt. By selling your assets, you will still owe $5,000, which makes it negative equity.

Shareholders Equity & Owner’s Equity

Let us now cover each of these types of equity in a business:

What is shareholders equity?

Shareholders equity is the difference between the total assets and liabilities in a company. This is also the share capital retained in the company along with the retained earnings minus treasury shares. It is the amount that reflects how the company has been financed with the help of the preferred shares and common shares. Shareholders equity is also the net worth, stockholder’s equity, or share capital.

There are two sources from where the shareholders equity comes from, one being the money invested in the business and all the other investments made for the company to run smoothly. The second source is the earnings the company retained over time from its operations.

Formula of Shareholders Equity

The way to calculate the shareholders equity is by using the following formula:

The first formula involves the total assets and liabilities, which makes it easy to use and is considered to be a simple accounting equation. To get the total assets, you will need to add all the current and long term assets in the business. The long term asset in the company is the property and capital assets, while the current assets are the receivables and cash of the company. Whatever you add in has to be held at least for a year in the company. After this, you will need to add the liabilities, including the current and non-current liabilities.

The second formula is called the investor’s equation, where you have to get the share capital of the company and then ascertain the retained earnings of the business. Verify all the retained earnings, ie. the profits made in the company. After this, determine the number of treasury shares, which are the shares that the company sells and repurchases. By adding the values in the formula, you will get the shareholders equity.

What is the owner’s equity?

The next part is the owner’s equity. It is one of the three main sections of a balance sheet and the equation for it is:

Here, the owner’s equity in a business is the investment made in the business minus the owner’s withdrawals, plus the net income (or minus the net loss) since the business began. This equity is viewed as the residual claim on the business assets as the liabilities have a higher claim. It is also viewed as a source of the business assets.

Let us take an example; there is a company whose accounting records show assets of $120,000 and liabilities of $80,000, and the amount of owner’s equity of $40,000. Because of the cost principle, the amount of the owner’s equity should not be considered to be at fair market value.

Types of Equity

There are many types of equity that together make up the shareholders equity. Just to be clear, equity in a business is the amount funded by the shareholders and owners in a company for the initial startup and the continuous operation of the company. The total equity represents the residual value left in the assets after all the liabilities have been paid off. It is then recorded in the balance sheet of the company. Here are the most common types of equity:

Common stock

Common shares or common stock is the type of equity that represents the initial investment made in the company. With this equity, the shareholders get certain rights to business assets. The common stock is recorded at par value, which means the face value of the stock. And the total common stock capital can be determined by multiplying the number of outstanding shares with the stock’s par value. Just to be clear, the owners of the common stock have more control over the business and its management.

Preferred Stock

Preferred stock or preferred shares are given to the investors in a company and offer a fixed dividend. In case the company is being wound up, the preferred stockholders would get all the amount that the company owes them before the common shareholders. And if the dividends were suspended due to some issue for preferred shareholders, when the company is about to wind-up, they are paid first.

In fact, preferred stock can have their features altered by the company for making the agreements more appealing to potential investors. For example, there can be call and convertibility provisions in it. But these shares do not offer rights to any company operations or to manage the company. Nor do the shareholders get any voting rights as well. The only benefit is that they will get dividends regardless of what happens to the company.

Contributed surplus

The contributed surplus capital equity, also known as the additional paid-in capital equity, gathers the additional amount the investors pay for shares above its par value. This account is usually higher than the other accounts, and can change as the company has gains and losses from selling shares.

Retained earnings

The next type of equity is retained earnings equity. This account reflects the earnings that the business accumulates minus the dividend payments made to shareholders. Simply put, the retained earnings is the part of net income in the company that was not paid out as dividends. This can be used for investments or you can save them for the future.

Treasury stock

Some businesses choose to buy back shares from their shareholders. When they do this, the repurchased shares fall under the category of treasury stock. Treasury equity in a company accounts for the amounts paid to buy shares back from investors. This equity account is normally a negative balance and is added to the accounts as a deduction from total equity.

Issue & Manage Company Shares on Eqvista

With this you now know all about the different types of equity in a company. And keeping track of your company equity is very important. The best way to go about this is by using a great cap table application.

Eqvista is a cap table application that operates with advanced technology. You can easily track and manage all the shareholders equity of your business and issue shares electronically.