What is Equity in Business?
Most will normally associate the word “equity” with the pursuit of justice, especially those related to social issues such as race or gender, but this is not what it usually means in business. Equity in business is instead related to the value of a company’s assets, and how much money these assets could make if sold.
But what does this mean, exactly, and how does it work?
We’ve explored these questions and others, and answered them in more depth below. Take a look and find out everything you should (and need) to know about equity, the types you can come across, and how it works for different businesses, firms, and organisations.
What is Equity in Business?
Simply put, equity in a business is the amount of money that could potentially be returned to different groups of people, if a business goes into liquidation and its debts are paid off. It measures the value of ownership and tells the owner, owners, or shareholders how much they might be paid if they chose to sell the asset that they currently have.
As a concept, equity can be applied broadly to entire companies and organisations or narrowed down to refer to the market value of a single item. Businesses will list their overall equity on their balance sheet, taking into account retained earnings with the value of inventory and other assets. Then, liabilities such as loan debt, salaries, and taxes are subtracted from the amount. You can normally get a good insight into a company’s health by looking at its equity, and it’s often known as a company’s “value on paper” for this reason.
What are the Different Types of Equity in Business?
There are several different types of equity in a business, each of which you’ll need to know about if you’re intending to start your own company:
This is how much any particular business is worth if it goes into liquidation and all of its debts are paid off. It represents the capital that’s theoretically available for distribution to the owner of a sole proprietorship (a small business, for instance) or the owners of a partnership.
In the balance sheet of a sole proprietorship, owners’ equity refers to the total of these transactions:
- + Original owner investment in the business
- + Donated capital
- + Subsequent profits made by the business
- - Subsequent losses made by the business
- - Subsequent distributions to the owner
Once this has been calculated, you should be left with an amount totalling ownership equity.
This is the amount of money that would be returned to a company’s shareholders if all its assets were to be liquidated and its debts paid off. It’s also known as “stockholders’ equity”. In the case of large firms or corporations, this is the same thing as owners’ equity, as the shareholders take on that role instead. The equity of a corporation owned by one person should also be listed as shareholders’ equity because that one person owns 100% of the shares.
To put it simply, shareholders’ equity measures a company’s net worth. It’s the net amount of a company’s total assets and liabilities, listed on the company’s balance sheet. It also partially shows how much of the company’s operations are financed by equity.
Shareholders’ equity also includes retained earnings. This is the amount of profit left over from a business that will be used to pay dividends, pay off debts, or buy back shares of stock.
This is considered an alternative investment class, consisting of capital not listed or publicly traded on a stock market or exchange. When an investment is traded publicly, the market value of equity is readily available by looking at the company’s share price and its market capitalisation (the total value of all of a company’s shares of stock). This isn’t feasible with private equity because the market mechanism doesn’t exist, so alternative valuation forms must be carried out to estimate value.
The accounting equation used to determine shareholder equity (Total Assets - Liabilities = Shareholders’ Equity) will still apply to arrive at an estimated book value. Privately held companies can then seek investors by selling off shares directly, in private placements. These “private equity investors” can include institutions like pension funds, university endowments, insurance companies, or accredited individuals.
Private equity is often sold to funds and investors that specialise in direct investments in private companies, or that engage in leveraged buyouts of public companies.
Private equity tends to come into the equation at different points in a company’s life cycle. The first time a company is likely to experience or receive private equity investments is right at the beginning when it has no revenue or earnings of its own - and can’t afford to borrow. This is the time when a business owner will have to rely on funding from friends, family, or angel investors – the latter of these being a form of a private investor.
How Does Equity Work?
In financial terms, equity represents different types of business value and therefore has multiple uses:
As previously mentioned, equity can refer to the ownership interest a person (or multiple people) holds in a company through securities or stock. Investors can own equity shares in a business in the form of common stock or preferred stock (preferred stock is paid out to shareholders before common stock). Equity ownership in a firm means that the owner of the business shares that ownership with others. These other people are known as shareholders or stockholders.
The equity of each share may be represented as the cash value a person could receive if they decided to sell it. This value changes throughout the day when a stock market is open and running (commonly called a “trading day”), owing to market forces. An investor can assess their total equity stake in a company by multiplying the equity value of a single share by the number of shares that they own altogether.
If a trader carries out margin trading, meaning they are borrowing money to buy stocks, then that trader’s equity is the value of the stocks in their account minus what has been borrowed from the brokerage.
On a company’s balance sheet, total equity is represented by the sum of both types of stock (common and preferred), paid-in capital, and retained earnings.
When discussing equity in terms of property, equity is the difference between the property’s fair market value and the balance that is owed on its mortgage.
This refers to ownership equity. If a business goes bankrupt and has to liquidate its assets, this form of equity will be the amount of money left over after the assets have been sold and all creditors have been repaid. There may not always be ownership equity left after the last of a company’s debts have been paid.
Positive and Negative Equity
The equity of a business can be positive or negative. Having positive equity means that you have enough assets to cover your liabilities. On the other hand, negative equity means that you have more debts to pay than you have assets to cover their payment.
To give an example, imagine that you own a tech repair shop. You rent the shop space itself, meaning that this isn’t an asset for you. However, you do own around £10,000 worth of equipment and accounts that are receivable from your customers. You took out loans to get your business off the ground, but now you owe around £4,000. This means you have around £6,000 worth of equity in your business.
If at a later stage, you need to take out more loans to keep on operating and these total more than £10,000, then you would have negative equity. It means that you could sell off all of your assets and collect all of the accounts receivable, but you still wouldn’t have enough to be able to cover your debts.
Equity isn’t only limited to tangible assets. When calculating equity in a business, the total value of assets should include both tangible and intangible assets. Tangible assets are the physical possessions that a company owns, such as property, facilities, and product inventory. Intangible assets, on the other hand, refer to a company’s reputation, intellectual property, and brand identity.
Intangible equity is almost an investment in itself; it’s built up over years (and sometimes decades and centuries) of being in business and faithfully serving your customers to instil brand loyalty. Large corporations that have been around for many years and served countless people are therefore more likely to have intangible equity than a business which is only just finding its feet.
You can see a real-world example of this by looking at the prices of brand-name items in the supermarket, compared to generic items. They might, by and large, be the same product (some might have even been made in the same factory), but the generic version will usually be sold at a cheaper price. This is because the brand-name product has intangible value, based on its connection to a well-known brand name.
Selling Your Equity
One of the things you might consider doing if you want to hire more people for your team or rent new premises is selling equity. To get the funding you want, you’ll need to give away a share of said equity, which is typically represented as a percentage. For instance, an investor may offer you £150,000 for a 25% share of your business.
When you decide to sell equity, your shareholders will have the right to the value of their share in the company when they sell it, or when the business is sold or goes into liquidation.
Before you decide to sell equity, you’ll first need to:
- Work out the equity of your business, so that you know how much it’s worth before you start
- Decide on how much of the investment you want and the share of equity you want or are willing to give away
- Make sure you’re prepared to give up some control; you’ll have shareholders, and they’ll have some say over things that the company does
- Set up a realistic time frame so that you have a plan to work from and a goal to work towards
What is Equity Funding?
Equity funding is just another way of saying that you’re selling equity. Some of the most common forms of equity funding include:
- Angel investment
- Venture capital
Equity in Business and Accounting
Equity is used in a firm’s accounting when preparing a balance sheet or other financial statements. As the owner of a business, you can decide whether you do this yourself using accounting software, or hire a professional accountant to do it for you.
Are You Looking for New Premises?
If your company is getting off the ground as you have planned and you’ll soon need more room to accommodate your team and physical assets (like equipment), contact Halkin. We’re more than confident that we can set your company up in one of our stunning yet affordable offices to rent in London, and offer you a flexible tenancy agreement that suits the needs of your business.
On the other hand, if you’re only just starting and need to meet with potential partners, investors, and shareholders first, we’ll also be glad to hire out one or more of our comfortable yet impressive meeting rooms. These spaces are designed with your success in mind, and we’ll do everything we can to help you take your business or business idea to new heights – however you need us to.