Equity capital is one of two types of funding a small business uses to finance its operations. It represents the money contributed by owners and investors and a company’s reinvested profits. Unlike debt financing, equity capital does not require repayment. A corporation reports equity capital in the “stockholders’ equity” section of its balance sheet, while a sole proprietorship reports it in the “owner’s equity” section. Knowing the types equity capital can help you make funding decisions in your business.
Common stock capital is an example of equity that a corporation obtains from owners and other parties. A company issues shares of common stock in exchange for cash. Each share conveys an ownership position in the company. Common share owners typically have the right to vote on important company matters and can potentially receive periodic dividends. For instance, if you and two family members each put in $50,000 to start a corporation, you would each get an equal number of shares of common stock.
A corporation can also raise equity by issuing preferred stock. Preferred stockholders own part of the company but have no voting rights. A business typically pays fixed dividends to preferred share owners and distributes these payments before paying common dividends, although it is not obligated to pay any dividends. Preferred share owners also get paid before common shareholders if the company liquidates its assets. For example, if you issue $50,000 of preferred stock with a 5 percent annual dividend, you would distribute $2,500 in preferred dividends annually.
Retained earnings represent the profits a company has kept in its business since it began that it has not distributed as dividends. This is an example of internally generated equity capital. Although these reinvested profits belong to common stockholders and increase their proportionate stake in the business, a company decides how to spend retained earnings. A corporation reports retained earnings separately from common and preferred stock in the stockholders’ equity section of the balance sheet.
A sole proprietorship is a type of business entity with one owner. Unlike a corporation, a sole proprietorship reports all equity capital in one account in the owner’s equity section of the balance sheet called “capital” or something similar. This account contains the money the owner has contributed and the profits she has retained. A sole proprietorship does not issue stock. For example, assume you contribute $25,000 to your sole proprietorship and retain profits of $30,000. Your capital account would have $55,000.