Business equity is defined as assets less liabilities, and your company’s total equity represents the true value of your firm. Equity is increased when your business generates a profit, and when investors contribute assets to your operation. Finally, if you decide to sell your company, the sale price will be based on your business equity balance, among other factors. Put simply, equity means ownership.
Understanding equity is critically important because your company needs equity in order to purchase assets to operate the business. You need to understand what equity is, how the balance can change, and what investors expect from you when they contribute equity into your business.
Balance Sheet Components
Equity is a component of the balance sheet, which is created using the balance sheet formula:
Assets – liabilities = equity
A balance sheet provides detail for each of these categories:
- Assets: Assets are defined as resources that are used to generate revenue (sales) and profits in the business. An asset may be tangible, such as a vehicle, or intangible, such as a patent or other intellectual property.
- Liabilities: Liabilities represent amounts owed to other parties, including accounts payable and long-term debt.
- Equity: Equity is the difference between assets and liabilities. If, for example, you sold all of your assets for cash, and then used the cash to pay off all liabilities, any cash that remains is your equity balance.
Creditors (those who are owed money), and investors each have a claim on the assets of a business. The total dollar amount of claims equals the total asset balance. A company with $500,000 in total assets, for example, may have $270,000 in liabilities and therefore $230,000 in equity.
The balance sheet formula must stay in balance, regardless of the number of transactions posted, or the dollar amount of accounting activity. Using accounting software allows you to post balance sheet transactions correctly.
Your firm’s equity balance is the sum of three account balances:
- Common stock: When you issue shares of stock to investors, the common stock account increases. Each share of stock is assigned a par value, which is a dollar amount used to post activity to the common stock account. If, for example, you issue 100 shares of stock at $20 par value, the common stock account increases by $2,000. Investors typically pay cash in exchange for common stock.
- Additional paid-in capital: When a company issues common stock at a price that is greater than par value, additional paid-in capital is created. If your firm issues 100 shares of $20 par value stock for $30 a share, $2,000 (100 shares X $20) is posted to common stock, and the remaining $1,000 is posted to additional paid-in capital. The issue price for common stock is determined by investor demand and the profitability of your company.
- Retained earnings: The retained earnings balance is defined as the sum total of all company earnings since a firm’s inception, less all dividend payments to shareholders since the company started operating. A dividend is a distribution of company earnings to shareholders.
As you can see, your equity balance is the sum of money you raise from investors, plus business earnings that you retain and use to operate the business. The more equity that you sell, the less personal ownership you will have in your company.
How Equity Changes
There are four basic transactions that change the equity balance, and these transactions are frequently misunderstood. Business owners often don’t post these transactions correctly, which means that the equity balance is incorrect. Make sure that you understand these accounting concepts, in order to maintain a correct equity balance:
- Generate a profit: When your business generates a profit, the retained earnings account increases.
- Raising equity: If you raise money from investors, your equity balance increases. Investors most often contribute cash, but an investor may also contribute machinery, equipment, or other assets.
- Producing a loss: A company loss for a month or year reduces the retained earnings balance.
- Distributions to investors: The equity balance decreases when you pay a dividend (a share of company profits) to investors, and when an investor withdraws any of the original dollars that they invested.
Your business will post some type of equity transaction each month and year. To ensure that you’re posting equity transactions correctly, have an accountant review your accounting records each year.
Who Contributes Equity
There are a variety of people who invest in companies, and the differences are based on investor sophistication, and the dollar amounts invested. Investors profit from dividend payments, and by selling their ownership interest for a gain. The investor’s goal is to provide funds to a business that can increase sales and profits.
Broadly speaking, there are three types of equity investors:
- Business associates: Small businesses typically raise equity from people who know a great deal about the company and the industry. Assume, for example, that Sally owns three restaurants, and needs to raise equity. She may bring in investors who know her personally or find another restaurant industry veteran who decides to invest. These people are considered private investors.
- Private equity investors: Private equity firms raise money from wealthy, sophisticated investors, and invest pools of money in private companies. Private equity investors are required to leave investment dollars in the business for 5-10 years, and a private equity firm is often heavily involved in managing the business once the investment is made. Generally speaking, private equity firms are more demanding than other private investors, and they will make company changes to generate high returns for their investors.
- Shareholders: Sally may decide to issue common stock shares as a public company, which allows her to sell shares to any type of investor. This decision requires Sally to register shares with the Securities and Exchange Commission (SEC) and to provide extensive documentation to investors, including audited financial statements. The additional documentation provides disclosure to investors who may not be as sophisticated or wealthy as private investors.
Think carefully about the types of investors you want to bring into your business. Investors expect a rate of return from their investment, and they want a voice in how the business is operated. The larger percentage of ownership you sell, the less control you’ll have over the business.