The Importance of Equity
For a business owner, equity is the net value of her investment in the business. This is simple enough, and it is obviously an important matter for any entrepreneur. There are other reasons why the equity in a business is important. When there are multiple owners, the proportion each investor owns is a key determinant of her influence on business decisions. The ability to use equity financing can make the difference between growth, stagnation and even failure of the company.
The equity in a company or other business is equal to the total investment the owners have made in the business plus all of the profit the business has earned since it began operations. This amount is reduced by any losses or payments to owners in the form of draws, or withdrawals or dividends paid to shareholders. For example, if a business owner has invested $100,000 in the firm, the business retains another $50,000 in profits and there are no other owners, his equity equals $150,000.
The equity in a company is reported in the third section of the business's balance sheet. It is usually called owner's equity unless the firm is a corporation. Then it is called shareholder's equity. Equity is the amount remaining after total liabilities are subtracted from total assets.
Equity is broken down into equity capital, also called paid-in capital, which is the amount owners have invested, and retained earnings. Retained earnings equal the total profits the firm has earned and not distributed to owners or shareholders since the company started.
You should know how investors determine the worth of a company in order to understand the importance of equity. Equity is one method of assessing a firm's value and is sometimes called the book value because it is the figure that appears on the financial records of a business. However, book value is an entirely separate metric than market value. Market value or market capitalization is the amount investors are willing to pay for an ownership share.
Suppose the ABC Company has 1 million shares outstanding and equity equaling $9 million on the balance sheet. You might expect the price of the stock to be $9 per share, but upon checking the current price, you see the stock is trading at $15 per share. Multiplied by the number of shares outstanding, you find that the market value of ABC Company is $15 million. This is considerably more than the equity and indicates investors have a favorable view of the company's future prospects.
An entrepreneur must raise money to start and grow a business. Often he begins with only his own money as capital. Additional funding typically comes either from equity financing, meaning the process of finding other investors who will provide capital, or by borrowing money by way of bank loans or selling bonds. Quite often, the choice between equity and debt financing comes down to which is most readily obtained at a given time. Most businesses use a combination of these two sources of capital.
Equity financing has some advantages. The money does not have to be repaid, unlike a bank loan or bond. There are no finance charges, which is helpful for a startup that wants to channel money into growth. Equity financing also means the company isn't obligated to pay interest during hard times and won't be limited by restrictions on the use of capital imposed by banks or other lenders.
Equity financing does have a downside. When a business owner sells partial ownership to raise capital, she must share future profits with other investors. In addition, partners or shareholders typically want a say in how the business is run. In the end, entrepreneurs must choose the best balance between equity and debt financing in order to achieve their goals.