In the world of finance and business, you will hear the term "equity" come up often. While there are different kinds of equity, it’s important to know how it works in your small-business context. Understanding how equity works can help you make important decisions such as how to finance your business and how to grow your stake in a business.
TL;DR (Too Long; Didn't Read)
Equity refers to how much ownership interest you have in a business. This can be in the form of shares or stock held, and it can also be the amount of assets your business owns minus any liabilities you have. This is typically how equity is shown on a company’s balance sheet.
The Definition of Equity in Business
Assets are anything you own in the business that has monetary value, such as equipment, property, inventory or trademarks. Liabilities are any debts you owe to vendors, organizations, lenders or agencies. In essence, the formula for equity is assets minus liabilities.
For example, if you have a flower-delivery business and have two vehicles that are worth $25,000 total, those are your company’s assets. If you have $10,000 left on your vehicle loans, those are your liabilities. That means that the equity you have in your business is $25,000 - $10,000 = $15,000.
It’s always important to know how much equity you have in your small business because you can use equity in a number of different ways. For example, if you want to get a lower interest rate when borrowing money from a bank, you will need to show how much equity you have in the business. Similarly, if you want to get a larger line of credit for your business, the bank will want to see your equity.
You've probably heard equity in the context of real estate. If you have been paying your mortgage for a few years, or the value of a property has increased otherwise, you have equity in your home. You can borrow against this equity in the form of home equity lines of credit or a home equity loan. In this context, your lender — who is already an equity holder in your home if you have a mortgage with them — makes an equity investment by giving you an amount of money in exchange for a greater loan payment, secured by your home's value.
Understanding Tangible and Intangible Assets
Keep in mind that your assets, which relate to how much equity you have, can be either tangible or intangible. Tangible assets are things you can actually touch, like your product inventory or your retail store. It is easier to assign a monetary value to tangible assets because they can be bought and sold.
Intangible assets, on the other hand, are harder to pin down, but they do add to the value of a business. Intangible assets include your company’s brand reputation, intellectual property or customer relationships. These elements still have value, and they add to your intangible equity, which is hard to depict on a balance sheet.
Consider working on your brand for decades so that it is easily recognizable in your neighborhood to your target market. Compared to a completely unknown brand, this intangible asset has more value. Similarly, a standard operating procedure that you spent years refining to help your business run more effectively is intellectual property that adds to the intangible equity in your business.
Different Kinds of Business Equity
The term "equity" is used in many different scenarios when it comes to business and financing. It’s critical to understand how equity relates to your situation, especially if you’re making decisions about the financial status of your business. A commonality in all of the different types of equity is that it is typically the sum of assets, inventory and earnings.
Different types of business equity include:
- Ownership interest: This is the most common reference to equity where it concerns entrepreneurs. Your equity can be in the form of securities or stock. If your company is not a publicly traded corporation, then your equity is known as private equity. The people who own equity in a business are called shareholders.
- Balance sheet: On this financial statement, your total equity is calculated by adding the stock, paid-in capital and retained earnings. Your equity in the business is also calculated by adding all of your assets and subtracting your liabilities or debts.
- Bankruptcy: If your business declares bankruptcy and you have to liquidate all of your assets, any money that is left over after you repay all of your creditors is called ownership equity.
- Real estate: The difference between the market value of a business or residential property and the amount owed on the mortgage is called real estate equity. It’s how much of the property you own.
- Equity financing: This is when you sell shares of your business to external investors in order to raise capital to finance your company.
- Equity compensation: In some companies, business owners provide employees with a percentage of company profits instead of offering salaries up front.
Equity on Your Balance Sheets
The number of owners you have in a business affects the amount of equity you have. If you are the only owner in a business, then you have all of the equity. If you have business partners or you sell stock or shares, then you split the equity in your business. It’s important to record your equity properly on balance sheets so you also reflect the number of owners.
On a single-owner balance sheet, you would list all of the assets and subtract all of the liabilities. What is left is the owner’s equity, and it belongs to the single business owner. If there are multiple owners, then you have to track the equity for each owner. If an owner pays dividends to shareholders, then his own equity would change. Similarly, if money is withdrawn from the business, then the equity would change.
Pros of Having Equity
The more equity you have in your company, the more control you have in your business. For example, if you are a single owner and you have positive equity in your business, you can make all of the decisions regarding your company. If you share ownership, then you may need to consult your partners or shareholders regarding the future of your company.
The valuation of your company, which is what your company is worth, is based on equity. If your company has a large negative number as your equity, that will affect the valuation of your company. This means that you have a lot of liability that affects the price for which your company can be sold.
Cons of Having Equity
Having equity in your company isn’t a negative aspect. However, you may lose your assets and thereby your equity if your company goes bankrupt. You may have to sell your assets in order to pay back your creditors. If there is no money left, then you will not have any ownership equity left in your business.
If you use equity financing to raise capital for your business, then you will dilute your equity in the company. Whenever you bring on a new investor or distribute shares, any future profits your business makes will need to be shared between all investors, not just you.
How to Grow Your Equity in Your Company
You lose equity in your business if your liabilities increase. For example, if you incur a large debt to a supplier, that reduces your equity in the business because it increases your liabilities. As a result, in order to increase your equity in the business, you have to reduce your liabilities. When you pay back the debt, your equity will grow.
Your equity can be either a positive number or a negative number. If your equity is positive, that means you have less liabilities than assets. If you have negative equity, then you have more liabilities than assets. It’s important to have a positive number so that the business retains its valuation.