When you start a sole proprietorship, you own the entire business. Or, in financial terms, you own all the equity. However, as you take on investors or business partners, or hire employees, you might offer them an ownership stake in the business. All of these partial owners, including you, can share the rewards from your company’s success.
Although equity is made up of several different components in corporatefinancial statements, it’s really just another word for ownership. Here’s a detailed look at the role of equity in business and what it can tell you about a company’s status.
What is equity in business?
Equity represents an ownership stake in a business. It doesn’t matter whether the business is a one-person operation with a single owner or a giant multinational corporation with millions of investors who all own a sliver of the company—equity refers to the same thing.
Equity can be—and often is—divided into many pieces. If you start asole proprietorship, you have 100% of the equity. If you run apartnershipwith one other person and split ownership equally, you each have 50% of the equity in the business. Add a third person with equal ownership, and each of you has 33% of the equity.
As businesses grow, they often take on outside equity investments. These might be from silent partners who buy a portion of the company but who don’t want to participate in running it. Other partners might want to own a share of the company and seek a management or advisory role in the company.
For private companies, outside equity investments might come from relatives and friends, or from professionals such asangel investors,venture capitalists, and private equity funds. Some companies also raise money from groups of people through crowdfunding campaigns. Certain companies, especially high-growth startups, sometimes pay employees with equity in the form of shares in the business. They often do this to attract talent while preserving cash needed to fund growth.
Once a company goes public, it can sell equity to investors on the stock market. The equity owners are then known as stockholders or shareholders, and they can very easily sell their shares in the public markets. New investors, in turn, can buy shares in the company to become partial owners.
When companies make money, they can pass on those earnings to the equity owners as distributions or dividends. The equity owners can also make money if the company is acquired and they receive more for their ownership stakes than they originally invested. They also profit if they can sell their shares on the open market for more than they paid.
Types of equity in business
Although equity refers to ownership in a business, there’s often a distinction between owner’s equity and shareholders equity, depending on the structure of the business.
Owner’s equity
Owner’s equity represents the business owner’s stake in the company. You commonly use the termowner’s equityin reference to a sole proprietorship or single-memberlimited liability company(LLC) because the business owner is the only owner. If the company is a partnership, you might refer to the ownership equity as partnership equity instead.
Shareholders equity
You generally use the term shareholders equity, or stockholders equity, once the company has many owners, especially if it sells equity in an initial public offering (IPO) on the stock market. In a public company, the original company founders almost always still own a portion of the company, but other investors are shareholders as well.
Shareholders equity, especially for public companies, is sometimes broken down into several components:
- Share classes.Companies might have different classes of stock that give varying rights to the owners. For example, there might be common and preferred stock—preferred stockholders get paid before common shareholders if the company liquidates. In other cases, companies give some shares more voting rights on corporate governance than others. This structure, used in companies such as Facebook and Berkshire Hathaway, often is used by the earliest investors to retain management control.
- Paid-in capital.When public companies sell stock directly to investors, the money received is recorded on the company’s balance sheet as paid-in capital.
- Retained earnings.Companies might decide to keep and reinvest earnings in the business instead of paying out distributions or dividends. This money is called retained earnings. Although the equity holders won’t receive their cut of those profits right now, the reinvestment can help increase the long-term value of the company, which may eventually be reflected in higher share prices.
- Treasury stock.Also called reacquired stock, these are shares that the company bought back from investors on the open market. Companies might do this when they think their stock is undervalued or don’t think using cash for expansion will yield adequate returns. The company can then sell back the shares to investors to raise money in the future. Or it can retire them, thus increasing the ownership stake of the shares held by the remaining investors.
How to calculate equity
The formula to calculate business equity is simple:
Assets - liabilities = equity
For public companies, the information for this calculation is found on theirbalance sheets, which they are required to include in their quarterly (10-Qs) and annual reports (10-Ks).
Consider exercise-equipment makerPeloton’s 2022 annual report, which includes a consolidated fiscal year-end balance sheet dated June 30, 2022. To calculate shareholder equity, start by finding the line item that lists total assets, in this case, $4.0285 billion. Another balance sheet line item shows total liabilities, which were $3.4356 billion. Subtracting liabilities from assets shows that shareholders equity was $592.9 million, which indicates that Peloton is a positive equity example.
For private companies, the same calculation holds true: You derive the equity value from your company’sbalance sheetby determining the total value of the assets, then subtracting the liabilities. If the company has multiple owners, your equity will be equal to your ownership stake.
The amount of equity in a company often changes. For example, when a company’s assets increase and the liabilities stay the same, the value of the equity rises and an investor’s stake is worth more. Conversely, if total liabilities climb faster than assets, the equity is worth less. Net losses, and paying distributions or dividends, also reduces equity. Finally, if the company declares bankruptcy because it can’t pay its debts, the equity holders might be wiped out.
Equity in business FAQ
How does equity contribute to a company’s financial stability?
Equity is an important element of a business’s financial health. Investors might review a company’s assets, liabilities, and equity to help them understand its financial condition. Positive equity that’s increasing might mean the company is stable and prospering. Equity also represents a financial safety cushion, because a company’s net losses come out of retained earnings, a component of equity. More equity allows a company to absorb setbacks or net income losses and remain in business.
How does equity increase a company’s value?
Equity reflects, but doesn’t increase, a company’s value. Specifically, equity represents how much value is left for the company’s owners—the shareholders—once the company pays its liabilities.
How can a company maintain a healthy equity position?
Companies can maintain a healthy equity position by being profitable and adding to their retained earnings or selling shares to boost paid-in capital. Paying down debt—a liability—can also improve a company’s equity position.
Can equity be negative?
Equity is negative if a company’s liabilities exceed its assets. Negative equity can be a sign that a company is in trouble or even at risk of failure. However, some successful companies, such as Starbucks, have had periods of negative shareholder equity after taking on lots of debt, and can survive if they have strong and positive net income. Startups also often have negative equity during their early phases, especially if they take on debt to support growth in an effort to reach profitability.
Does equity financing involve borrowing money?
Equity financing doesn’t involve borrowing money. Equity financing is when you raise money by selling equity representing an ownership stake in your business. Debt financing is when you borrow money that must be paid back.