Equity is a necessary part of a business—from someone’s side hustle to the largest corporations, every business has equity from the moment it’s formed.
What you might not know is that equity operates as both a measurement of financial health and a tool businesses use to inject capital into their business.
So no matter the size of the business, you need to understand what equity is, how it's measured, and the ways you can use it to help hit your growth goals.
Definition of equity
Equity is the value of ownership in an asset or business.
You may hear it refer to somebody owning a stake in a company as part of their investment portfolio. When this happens, the buyer is essentially purchasing a portion of the ownership of an asset or business.
In business, you’re the one who is portioning up ownership among different stakeholders. In this case, you’re more concerned about the value you’re generating for the ownership as opposed to the value you get from ownership.
What is equity in business?
In a business context, equity is commonly used to refer to how much the business is worth. How much a business is “worth” is based on how much it owns versus how much it owes.
What a business owns and owes are called assets and liabilities respectively. You find a business’s equity by subtracting its liabilities from its assets., both found on the balance sheet.
Whether it’s the value of a sole proprietor’s one-person operation or a Fortune 500 company, all businesses have some amount of equity.
The key difference between these two examples is who the equity belongs to. A sole proprietorship’s equity belongs to the individual while a publicly traded Fortune 500 company would have its value spread out amongst anyone with shares or stocks in the business.
How to calculate business equity
The business equity equation is:
This equation may look familiar if you know the accounting equation. The equity equation is simply a reworking of the accounting equation to find the value of ownership.
You can find your assets and liabilities on the business’s balance sheet. Once you have those values, simply subtract the liabilities from the assets to find your equity amount.
Types of business equity
There are many types of business equity. What determines the type of equity a business has is the business structure and financing.
For example, an incorporated business has different equity than a partnership or sole proprietorship.
Let’s break down the most common forms of equity.
Owner’s equity
Found in: sole proprietorships, partnerships, some limited liability companies (LLCs)
Owner’s equity is the simplest form of equity. This refers to how much the ownership of the company is valued based on the equity equation and how many owners there are.
In a sole proprietorship, owner’s equity is held by one individual.
In partnerships, owner’s equity is divided amongst each of the owners based on the partnership agreement. If ownership is equal, it would be a 50/50 split amongst two owners, 33/33/33 split for three owners, etc. However, the partnership agreement may outline a different split.
Like sole proprietorships and partnerships, limited liability companies (LLCs) are not incorporated and cannot issue stocks.
Shareholders equity
Found in: public companies, corporations
Shareholders equity occurs when a business starts bringing on investment, in particular when the business goes public with an initial public offering (IPO).
In this case, shareholders hold a percentage of ownership in the business which gives them a claim to a percentage of the value a business would generate if it would liquidate all of its assets and pay off all of its debts. Owners may also get dividends from the business based on the profits generated.
Common stock
Found in: public companies, corporations
Common stock is a form of issuing ownership in the company that comes with the right to a company’s profits, value after liquidation, and direction through voting on corporate policies.
This form of equity is most commonly used when individuals or investment bodies want a say in how the business is run. With the added responsibilities come higher returns and higher risk for the stockholder.
While common stocks don’t guarantee a dividend to owners, the value of common stock has larger rises and falls meaning an owner can earn more through capital gains. Capital gains happen when the value of the stock increases because the business is performing well.
If someone believes they can help increase the value of the business, they’d prefer common stock so they get to reap the rewards of their efforts.
Preferred stock
Found in: public companies, corporations
Preferred stock gives owners the rights to dividends, however, it does not come with voting rights or any control of the company.
Holders of preferred stock are paid dividends before common stock shareholders. Typically, the dividends amounts for preferred stock will be higher than common stock.
The tradeoff is that preferred stock values are relatively stable. Shareholders are less likely to generate capital gains year over year, mostly generating income from dividend payments.
For shareholders, it's lower risk with lower reward. For the business, it generates investment without yielding control of the company.
Retained earnings
Found in: almost all businesses
Retained earnings may not seem like equity at first glance because there isn’t a component of ownership. Simply put, retained earnings represent the net income that’s reinvested into the business instead of being paid out as dividends.
As an example, if a business generated $100,000 in net income last year and pays out $80,000 in dividends to its shareholders, it holds $20,000 in retained earnings being reinvested in the business.
Retained earnings are an integral part of small businesses looking to finance themselves through their operations. Rather than paying out the net income a business has generated, that money could be used for new equipment, real estate, or other forms of investment without financing.
If you’re looking to use retained earnings to grow your business, you should get familiar with a statement of retained earnings.
Where to find equity
Equity is found at the bottom of the balance sheet.
The equity section will be divided into separate sections depending on the types of equity that have been offered to shareholders.
Depending on the business structure, you may find a combination of owner’s equity, common stock, preferred stock, or retained earnings.
You can also find total equity by using the equity equation:
Equity = Total Assets - Total Liabilities
Is equity good or bad in business?
Generally speaking, equity is considered a good thing in business so long as it's positive. If equity is positive, that means the business owns more than it owes.
However, whether equity is “good” or “bad” is a more nuanced question.
If a business is generating equity by selling more shares or stocks, then ownership is being diluted which means a smaller piece of the pie for the current ownership group.
This is especially notable if the business is selling common stock which is a controlling stake in the company. As the business issues common stock, there are more voices voting on how the business is being run.
Investors may also start to pressure the company to focus on short-term gains to maximize the return on their investment. These short-term gains could come at the cost of long-term strategy.
Ultimately, you should think about what you’re hoping to accomplish with the equity of the business. How will you feel about paying out dividends? What about voting rights? Or devaluing your portion of the business to bring on investment?
There’s no inherently right or wrong way to manage equity, but all businesses should aim to keep equity positive.
Examples of equity in business
The equity equation has one crucial component: if equity increases or decreases, assets and liabilities must increase or decrease by the same amount. If they don’t, the equation is no longer equal and the accounting must be wrong.
Let’s look at this in practice with some common examples of how equity changes in a business.
Raising investments
A business is looking to raise money to upgrade the equipment they use in their operations. They need $10,000 for the purchase and sell $10,000 in common stock to get there.
At the point of sale, both equity and assets increase by $10,000 with assets increasing by the cash they gain from the sale. At the point of purchase, the $10,000 is then moved from cash to equipment which is similarly recorded in the assets section of the balance sheet.
The equity equation shows:
Equity + $10,000 = (Assets + $10,000) - Liabilities
The $10,000 on each side cancels each other and we see that the equation holds.
Paying out dividends
Dividends are paid out of retained earnings. When this happens, equity decreases
Say a business is paying out $10,000 in dividends. Retained earnings go down by $10,000 meaning equity decreases by $10,000 as well.
Since dividends are paid out in cash (which is recorded in the assets section of the balance sheet), assets decrease by $10,000.
In the equity equation, paying out $10,000 in dividends looks like this:
Equity - $10,000 = (Assets - $10,000) - Liabilities
Since both sides of the equation go down by $10,000, the equation holds.
Generating retained earnings
In a given month, a business has generated $10,000 in net income. They decide to keep the money in the business as retained earnings.
With the $10,000 generated, $5,000 is going to be kept on hand to cover expenses while the other $5,000 will be used to pay down a credit card bill.
The equity equation is affected as such:
Equity + $10,000 = (Assets + $5,000) - (Liabilities - $5,000)
Equity + $10,000 = Assets + $5,000 - Liabilities + $5,000
Equity + $10,000 = Assets - Liabilities + $10,000
Once again, the equation holds because both sides are increasing by $10,000.
Equity vs debt financing
Equity is sometimes used as an alternative to debt financing for injecting money into a business. One isn’t inherently better than the other and knowing which one is right for you requires understanding the differences.
Debt financing means taking on credit as a loan or line of credit—you borrow money with the intent to pay back the balance in full with interest. How much you need to pay back is clearly documented before any agreements are signed.
Raising funds through equity means selling an ownership stake in the business. Depending on the type of share or stock sold, the buyer may be entitled to dividend payments or voting rights.
You don’t “pay back” equity in the same way you pay back debt. In fact, some cases of selling equity don’t require payouts at all as the buyer benefits through capital gains (the increase in value of the share or stock).
However, if you’re paying dividends, you’re committing to paying shareholders based on business performance. If the business starts generating more profit, you’re paying more in dividends.
There are also restrictions on what kinds of businesses can sell equity. For example, pass-through entities like partnerships or sole proprietorships cannot sell equity.
When choosing between selling equity or using debt financing, you should think about the following factors:
- Are you eligible to sell equity in the business?
- What is your credit history and what options are you eligible for?
- Are you willing to dilute ownership and potentially lose some control of the business?
- Will the costs of paying out dividends outweigh the costs of a loan or line of credit?
- How does each option fit into your long-term strategy?
Generally speaking, early-stage businesses look to raise funds through investment because they have less cost-effective options for debt financing. Late-stage businesses with a consistent cash flow are more likely to use debt financing since they can manage the payments and won’t dilute ownership.
Equity and your day-to-day operations
Equity is just one way of understanding a business’s financial health. But to develop equity, you need to think about optimizing your day-to-day operations and maximizing profits.
BILL Spend & Expense helps you do just that. Featuring seamless, automated accounts receivables and payables, budgeting tools, and full visibility into how money enters and exits the business, you can spend less time generating numbers and more time crunching them.
BILL customers saved time and money by making the switch*. Reach out for a demo to see how we can help you.
*Based on a 2021 survey of over 2000 BILL customers
