What is equity in business? Definition, types, and how it works

What does it really mean to own a piece of a company? That's the essence of "equity in business" – a concept central to understanding how businesses structure, finance, and ultimately, value themselves.

Starting a business often begins with a single founder who holds 100% of the equity, representing complete ownership. As the business grows, bringing in investors, partners, or even key employees usually involves offering them an ownership stake. 

This action inherently means sharing the company's success – and its risks. Understanding the ins and outs of equity in business is crucial, whether you're a seasoned entrepreneur or just starting.

In this guide, you’ll learn:

• What equity in business is
• Types of equity
• How to calculate equity
• How companies can turn equity into cash
• If equity financing is right for your business

What is equity in business?

Equity in business essentially represents ownership. It's a piece of the company pie, and the size of that piece reflects the percentage of ownership that an individual or entity owns. This concept applies whether we're talking about a small local bakery or a multinational tech giant.

Think of it this way: If a company is divided into 100 equal shares, and you own 20 of those shares, you have a 20% equity stake in the business. This ownership grants certain rights and privileges, including potential financial gains and a say in how the company is run.

Ultimately, equity represents the value remaining in a business after all its liabilities are paid off. It's the portion that belongs to the owners, and its value can fluctuate based on the company's performance, market conditions, and other factors.

Types of equity in business

To grasp the nuances of business ownership and investment, you must understand the different types of equity. While the fundamental concept remains consistent, the specific forms it takes can vary depending on the company's structure and stage of development.

1. Owner's equity

This type of equity is the most straightforward. It represents the ownership stake of the business owner(s) in sole proprietorships, partnerships, or single-member LLCs. In essence, it's the portion of the business that belongs to the individual(s) who started it and operates it.

• Sole proprietorship: The owner is the sole proprietor, and their equity encompasses all assets and liabilities of the business
• Partnership: Equity is divided among the partners based on their agreed-upon ownership percentages, as outlined in a partnership agreement

2. Shareholders' equity

For corporations, particularly those that are publicly traded, another type of equity comes into play: "shareholders' equity". This category encompasses the ownership interests of all shareholders, reflecting the collective value of their investment in the company. 

Shareholders' equity in business can be further broken down into several components:

Share classes

Companies can issue different classes of stock, each with its own set of rights and privileges. Common stock is the most prevalent type, typically granting voting rights and the potential for dividends. Preferred stock, on the other hand, often comes with priority in dividend payments and claims on assets in the event of liquidation, but may have limited or no voting rights

Paid-in capital

It represents the total amount of money a company has received from issuing its shares to investors. It reflects the initial investment made by shareholders when they purchase stock

Retained earnings

These are the accumulated profits that a company has reinvested back into the business rather than distributing to shareholders as dividends. Retained earnings represent a significant portion of shareholders' equity, evidence of the company's commitment to growth and expansion

Treasury stock

This refers to shares of a company's stock that it has repurchased from the open market. Companies may buy back shares for various reasons, such as to reduce the number of outstanding shares, increase earnings per share, or return value to shareholders

Understanding these different types of equity in business provides a solid foundation for analyzing a company's financial position and assessing its overall health.

How to calculate equity?

Calculating equity in business is essential for you to understand your financial position and for potential investors to assess the value of your company. 

While it might seem complex, the fundamental formula is quite straightforward:

Assets - Liabilities = Equity

Let's break down each component of this equation:

• Assets: These represent everything a company owns that holds value and can be converted into cash. Assets can be tangible, such as buildings, equipment, and inventory, or intangible, like patents, trademarks, and goodwill
• Liabilities: These are the obligations a company owes to others. Liabilities include short-term debts, such as accounts payable and salaries payable, as well as long-term debts, like mortgages and bank loans
• Equity: As a result, we obtain the residual value of a company after subtracting its liabilities from its assets. It's the portion of the business that belongs to its owners, reflecting their stake in the company's net worth

Regulatory bodies require public companies to publish their financial statements, including balance sheets that detail their assets, liabilities, and equity. Private companies also use this formula to calculate their equity in business based on their internal financial records.

Learn to calculate equity in the following example. 

Let's say a company has:

• Total assets: $10 million
• Total liabilities: $6 million

Using the equity formula, we get:

• $10 million (Assets) - $6 million (Liabilities) = $4 million (Equity)

Remember, equity in business isn't a static figure. It fluctuates constantly based on a company's financial performance, market conditions, and strategic decisions. Profitable operations increase equity, while losses chip away at it. Taking on new debt decreases it while paying down debt boosts it.

Mastering the equity equation provides valuable insights into a company's financial stability, growth potential, and overall attractiveness to investors.

Read more: A simple guide to invoice financing for startups.

How can companies turn equity into cash?

Now, let's shift our focus to a question for growing businesses: How can companies leverage equity in finance, securing the capital they need to expand, innovate, and thrive?

This is where the concept of "equity financing" takes center stage. It's the process of raising capital by selling a portion of the company's ownership in exchange for investment. Explore some of the most common avenues for equity financing:

1. Individual investors

In the early stages, founders often turn to their networks for funding small businesses. These individual investors could be friends, family members, or colleagues who believe in the company's vision and are willing to provide seed capital to get it off the ground.

2. Angel investors

Angel investors are typically high-net-worth individuals with an appetite for early-stage investments. They bring not only financial resources but often valuable experience, mentorship, and industry connections to the table.

3. Venture capitalists

Venture capital firms specialize in investing in companies with high growth potential. They typically invest larger sums than angel investors and take a more active role in guiding the company's strategy and growth trajectory.

4. Initial public offerings (IPOs)

An IPO marks a significant milestone for a company, representing its transition from a privately held entity to a publicly traded one. By offering shares of stock to the public for the first time, companies can raise substantial capital to fuel expansion and enhance their brand visibility.

Read more: What is alternative business financing?

Is equity financing right for your business? 

While the allure of securing capital without incurring debt can be enticing, equity in finance isn't a one-size-fits-all solution. It's a strategic decision with long-term implications, requiring careful consideration of your business's unique circumstances, growth trajectory, and risk tolerance.

Here's a breakdown of the potential advantages and disadvantages to help you determine if equity financing aligns with your overall business goals:

Advantages of equity financing

• Fueling growth without debt: Equity financing provides capital without adding to your debt burden, freeing up cashflow for operations and expansion
• Tapping into expertise and networks: Strategic investors can bring invaluable industry knowledge, connections, and mentorship to the table, accelerating your company's growth
• Sharing risk and reward: Equity investors share in both the risks and rewards of the business. Their success is tied to yours, fostering a sense of partnership and alignment
• Flexibility and growth potential: Equity financing can provide the flexibility to pursue new opportunities, pivot strategies, and scale operations more aggressively than traditional debt financing

Disadvantages of equity financing

• Dilution of ownership and control: Selling equity in business means relinquishing a portion of your company's ownership and potentially ceding some control over decision-making
• Potential for conflict: Misaligned visions or expectations between founders and investors can lead to disagreements and friction
• Pressure to exit: Some investors, particularly venture capitalists, have a defined exit strategy and timeline, which may not align with your long-term vision for the company
• Giving up future profits: While debt financing involves repaying a loan with interest, equity financing means sharing a portion of your company's future profits with investors

When does equity financing make sense?

• Early-stage companies: When traditional funding sources are limited and the business needs capital to develop its product, build a team, or reach early customers
• High-growth potential: When the company has a compelling growth story and needs significant capital to scale operations and capture market share
• Seeking strategic partnerships: When the right investors can bring not only capital but also industry expertise, connections, and guidance

When might equity financing not be the best fit? 

• Early profitability: If your business is already profitable and generating sufficient cashflow, debt financing or bootstrapping might be more suitable options
• Desire for full control: If maintaining complete control over your company's direction and decision-making is paramount, equity financing might not be the ideal path
• Short-term funding needs: Equity financing is typically a long-term commitment, not a quick fix for short-term cashflow challenges

The decision of whether or not to pursue equity financing is a strategic one that should be made in consultation with your management team, financial advisors, and trusted mentors. 

By carefully weighing the pros and cons and considering your company's unique circumstances, you can make an informed choice that positions your business for sustainable growth and aligns with your long-term vision.

Equity in business: Frequently asked questions (FAQ)

Equity vs. ownership: What's the difference?

While often used interchangeably, "equity" and "ownership" hold distinct meanings in business. Ownership signifies the legal right to possess and control a business, with all associated rights and responsibilities. Equity, however, represents the financial value of that ownership stake. It quantifies the owner's claim on the company's assets after accounting for all debts and liabilities.

How does equity contribute to a company’s financial stability?

Equity serves as a vital indicator of a company's financial health. A strong equity position, where a company owns more assets outright than it owes in liabilities, demonstrates stability and resilience. It reassures creditors and investors that the organization can withstand economic fluctuations and meet its financial obligations.

How does equity increase a company’s value?

While equity in business doesn't directly boost the company's value, it accurately reflects it. Equity represents the remaining value for owners after settling all debts. A growing equity position often signals a healthy and valuable business, but factors driving profitability and growth ultimately enhance value.

Can equity be negative?

A company's equity can become negative, a situation referred to as "negative shareholder equity." This occurs when its liabilities surpass its assets, often raising concerns about financial instability. While negative equity warrants attention, profitable companies with strong earnings potential can often overcome such situations through strategic restructuring or debt management.

Does equity financing involve borrowing money?

Unlike debt financing, equity financing doesn't require borrowing money. Instead, it involves companies selling ownership shares to investors in exchange for capital. These investors become part-owners, sharing in the company's risks and rewards, without any obligation for repayment like a traditional loan.

Choosing the right funding for your business

Equity financing has its place. Sometimes, bringing on investors means tapping into valuable expertise and networks. But what if you could grow on your terms without sacrificing control of your business? You built this company, you call the shots.

Stenn offers a different path: non-dilutive funding that lets you grow on your terms.

We're not your average bank. We're talking next-gen capital that lands in your account in days, not months. Explore flexible options like invoice financing and revenue-based financing – designed to unlock your cash flow and fuel your ambitions.

With Stenn, you can access the capital you need, when you need it, and spend it however you see fit. Backed by some of the biggest banks in the world, we’re the faster, easier way to capitalize on your vision.

Ready to grow without giving up control? Visit our website and discover how we can help your business thrive.