Equity in Business: An Essential Guide to Understanding and Calculating It

When you are bootstrapping a startup, typically, you and your co-founders hold all the equity. This equity represents your ownership and the value you have created in the company. However, as the company grows, you may find yourself sharing this equity with investors, consultants and your employees. These individuals then become part owners of the business, sharing in the rewards of your success.

At its core, equity in business represents the value of an ownership interest in the company, often in the form of shares. Understanding the implications of this tangible asset provides you with a better perspective on your startup's financial health. It can help you make informed decisions about funding, share distribution, and profit allocation. 

That's why, in this blog, we will cover all essential aspects of equity in business, including its meaning, types, importance, calculation method and more. Keep reading to learn more.

What is Equity in Business?

Equity in business is the residual interest in a company's assets after all liabilities have been accounted for. In simple terms, it is the remaining value when you subtract total liabilities from total assets at any given point in time. This value, or equity, is what shareholders and owners can claim as their stake in the company. Regardless of the size of their stake, each shareholder contributes to the company's equity.

The distribution of equity ownership varies depending on the business's structure. In a sole proprietorship, you, as the sole owner, hold 100% of the equity, whereas, in a partnership with equal ownership, each partner holds 50% of the business equity. If another equal partner joins, then each person's equity becomes 33%.

How Equity in Business Works?

The amount of equity in business is calculated by subtracting your company's total liabilities from its total assets. This 'assets-minus-liabilities' equation offers a transparent view of shareholder equity, allowing company's investors and analysts to easily interpret your business's financial health.

Equity is primarily built through two avenues:

• Capital Injection: This involves raising funds through share offerings or direct investments.
• Retained Earnings: Profits reinvested into the business, rather than distributed as dividends, contribute to equity growth.

Equity serves as the capital you raise, which is then utilized to purchase assets, invest in projects, and fund operations. As a founder, you might find that private investors and venture capitalists are attracted to equity investments because they offer a greater opportunity to share in your company's profits and growth.

Equity represents an investor's proportional ownership stake in a company based on the number of shares they hold. Shareholders benefit from potential capital gains, dividends, and voting rights on corporate decisions. Factors like company performance and market conditions determine the value of equity. Issuing new equity shares can dilute the ownership stake of existing shareholders. Different types of equity include common stock and preferred stock, each with its own set of rights and privileges.

Equity in business can be either positive or negative. Positive equity means you have enough assets to cover the liabilities, while negative equity indicates that your liabilities exceed your assets. Prolonged negative equity can signal balance sheet insolvency, which is considered risky by investors. However, shareholder equity alone is not a definitive indicator of your company's financial health. When used alongside metrics like cash flow analysis, profit margins, debt-to-equity ratio, and Return on Investment (ROI), equity helps assess your startup's overall well-being.

What are the Types of Equity in Business?

Equity in business can be broadly categorized into two main types: owner's equity and non-owner’s equity. Owner’s equity reflects the investment made by the owners (or founders), while non-owner’s equity, often referred to as investor or shareholder equity, comes from external sources who become shareholders after making an investment in the business.

Let’s understand the unique implications of both the equity types for you as a startup founder.

Owner's Equity

Also known as owner’s capital, it refers to the portion of the company that is owned outright by the founders. This includes the initial investment made by the founders, plus any earnings that have been reinvested in the business.

Let's understand the components of owner's equity:

• Capital Investment: This is the initial seed money that you, as the owner, invest in the company, along with any additional funds that you infuse over the course of business. This capital investment serves as the financial foundation of your company, providing the necessary funds to get your business off the ground and fuel its growth.

Non-Owner's Equity

Also known as investor’s equity or shareholder’s equity, it represents the ownership interest of external investors who have purchased shares in the company. These investors could be individuals, venture capitalists, or other entities who have invested capital in exchange for a share of ownership in the company.

• Stock Components: Shareholder's equity comprises common shares, preference shares, and treasury shares. Each of these represents a different aspect of ownership and company financing. some text
  • Common shares represent ownership in your company and confer certain rights to shareholders, such as voting on board elections, appointments of corporate officers, and other company policies. Common stockholders are entitled to dividends, although these are usually paid after preferred shareholders. 
  • Preference shares offer regular dividends from your company's assets and earnings, often on a fixed schedule. In contrast to common stockholders, preferred shareholders don't possess voting rights. However, they have the advantage of receiving dividend payments and asset distribution before others, especially in the case of liquidation.
  • Treasury shares are your company's own shares that have been repurchased from investors. These shares, held by your company, can be reissued or retired. Treasury stock is considered a 'negative' equity component because the funds used for repurchasing are deducted from your company's overall equity.
• Retained Earnings: Retained earnings within shareholder's equity represent the profits that have been accumulated over time but not distributed as dividends. Instead, these earnings have been reinvested back into the business to foster its growth. As an internal source of finance, you can use these earnings strategically to fund new projects, reduce debt, or buy back shares of stock.
• Capital Contribution: Additional shareholder contributions can enhance equity, providing extra funds for business operations and expansion. These contributions can come in the form of additional paid-in capital and can boost your company's financial health. Capital contributions reflect shareholders' confidence in your company's potential, positively impacting the market perception.
• Unrealized Profits or Losses: Unrealized profits or losses, also known as 'paper' profits or losses, have a considerable impact on equity valuation. They represent changes in asset values not yet realized through actual sales or transactions. These unrealized gains or losses can fluctuate with market conditions and can impact the perceived value of your company's equity.

Equity vs Debt: Detailed Comparison

As a startup founder, understanding the differences between equity and debt is crucial for your business strategy. Here is a detailed comparison of both these financing options and their impact on your company:

Ownership

• Equity: Equity financing involves selling a part of your company's total equity, giving investors part ownership in your business. This means that investors become shareholders and have a say in the company's decisions. 
• Debt: On the other hand, debt financing does not confer business ownership. It's a loan that your company is obligated to repay, but lenders do not have any claim on your company's future profits or decision-making processes.

Repayment

• Equity: It involves no mandatory repayments. Instead, investors are buying a share of your company's future profits. This offers more financial flexibility, as you don't have to worry about monthly loan repayments.
• Debt: Debt financing requires regular repayment of principal and interest, which can put a strain on your company's cash flow, especially in the early stages. 

Cost

• Equity: Equity financing often has a higher cost in the long run. This is because you are sharing a portion of your company's future profits with investors in the form of dividends. Additionally, issuing new shares can dilute the ownership stakes of existing shareholders. 
• Debt: In contrast, debt financing generally involves lower costs, as you are only required to pay the agreed-upon interest on the loan.

Risk

• Equity: This option is riskier for investors, as their returns are uncertain and dependent on the company's future profits. If the company doesn't perform well, investors may not see a return on their investment. 
• Debt: Debt financing, however, poses a risk to the business. It creates a fixed repayment obligation, which can affect cash flow and potentially lead to financial distress if the business is unable to meet its repayment obligations.

Control

• Equity: Issuing equity can dilute your control over the company as new shareholders gain voting rights. This could influence the company's strategic direction. 
• Debt: Debt financing, on the other hand, does not affect ownership percentages or control structures. Lenders have no voting rights and cannot influence the company's decisions if the company meets its debt obligations.

How to Calculate Equity in Business?

Calculating equity in business involves assessing your company's total assets and liabilities. Here is a step-by-step guide to help you understand this process:

• Assessing Total Assets: The first step in calculating equity is to determine the value of total assets. This includes all resources owned by your company, such as cash, inventory, property, and equipment. You can find this information on the balance sheet, which offers a snapshot of your company's financial position at a specific point in time.
• Calculating Total Liabilities: Next, you need to account for all the liabilities. This includes all debts and obligations your company owes, such as loans, accounts payable, and accrued expenses. Like assets, this information can be found on your company's balance sheet.
• Subtracting Liabilities from Assets: Once you have determined your total assets and liabilities, you can calculate equity using the formula:

Equity = Total Assets − Total Liabilities

This calculation gives you the net value owned by the shareholders, which is essentially the residual interest in the company's assets after deducting liabilities.

• Analyzing Financial Statements: Regularly reviewing your financial statements is crucial to verify your equity calculations. This ensures accuracy and provides valuable insights into your company's financial health and performance. Over time, tracking changes in equity can help you understand trends, identify potential issues, and make informed decisions about your business strategy.

Conclusion

Understanding equity in the business and its calculation is essential for you as a startup founder. It offers a clear snapshot of your business's financial health, influences decision-making, fuels operations, and attracts investors. However, managing equity can be complex and time-consuming. That's where we at Qapita can assist. 

We are a leading equity management platform, helping businesses manage all equity matters from inception to IPO. With Qapita, you can easily manage ownership stakes, issue equity awards, and handle valuation for accounting and tax compliance. Our platform offers cap table and equity management tools for your company's founders, finance, legal, reward, and HR teams. We also provide VCs with a holistic view of their portfolio companies, fund administration, and portfolio valuation and reporting tools.

Rated as the #1 Equity Management Software by G2, we are proud to support over 2,000 clients globally, engaging their investors and over 300,000 employees holding more than $55 billion of equity value. With our in-house experts in equity management, we provide a one-stop solution for rapidly growing companies, helping them enhance their employee experience and investor relations. 

Get in touch with our experts to learn more about our services.