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What is equity?
Equity is how much your business is worth.
More precisely, it’s what’s left over of your business once you’ve paid back everyone you owe money to.
It’s easier to understand equity once you see how it fits in with the two other parts of your business: its assets and liabilities.
Assets are what you have
Liabilities are how much you owe
Equity is how much you have left over
If we write this out in equation form, we get what accountants call the accounting equation:
Assets – Liabilities = Equity
This formula works regardless of whether you’re a Fortune 500 company or a one-person show with a side hustle.
How do I “get” equity?
Start a small business
If you own an unincorporated small business, you already have equity. In this case, it’s just the value of all your assets (cash, equipment, etc.) minus all your liabilities .
This kind of equity is sometimes called owner’s equity. If you own a partnership with someone, you probably agreed to split the owner’s equity with one or more of the partners in percentage terms. You might own a 70% stake in the company while your partner owns 30%, for example.
Incorporate and issue stock
Many businesses don’t officially start keeping track of the value of their equity until they incorporate.
In addition to choosing a name, appointing directors, and filing certain documents, incorporation also involves issuing shares.
Shares are small pieces of your company that are worth a certain dollar value. If you total up the value of all the shares you own, that’s your total stock in the company.
People used to get pieces of paper called share certificates (shown above) to show that they actually owned shares of a company. Some companies will still issue paper certificates if you ask them for one, but most stock today is handled digitally.
Your business’ board of directors can issue shares whenever, to whomever, and for whatever value it wants. When your company incorporates, it has to call a board meeting to decide how many shares each of the company’s original owners will get.
It’s a bit like when you and a business partner decide what percentage of an unincorporated partnership you’ll each own—but more official.
Buy stock in another company
Let’s say your friend owns a successful robot lawn mowing business (“think of it as a Roomba for grass,” he tells you) that you want in on. You were broke when the company first incorporated last year, but you have some extra cash now that you’d love to invest in the company.
You have two choices when it comes to getting equity in your friend’s company: you can buy existing shares from one of the owners, or you can wait until the company issues more shares and buy some of those.
Make a profit
If you run an incorporated business, one big decision you have to make every year is what to do with your company’s profits. Generally speaking, you have two choices:
- You and the rest of the company’s owners can keep the profits for yourselves by issuing yourselves a dividend. A dividend is just a cash payment that each shareholder gets. The more shares a shareholder owns, the larger their share of the dividend is.
- You can reinvest the profits in your business by holding onto them, in the form of retained earnings.
Equity in action
Business owners keep track of equity using the same tool they use to keep track of their assets and their liabilities: the balance sheet.
Let’s look at a balance sheet for a hypothetical business: Anne & Company.
Balance Sheet
Anne & Company Inc.
This business holds $16,000 in cash, a $4,000 MacBook, a $10,000 espresso machine, $10,000 in loans, $20,000 in common stock and $50,000 in retained earnings.
Let’s look at three events that can change the total equity of this business: issuing stock, paying out a dividend, and retaining profits.
Example #1: Issuing more stock
Let’s say that Anne & Company wants to buy another espresso machine, but they don’t want to take out another loan to pay for it. Instead, they issue $10,000 in stock. What would that look like on their balance sheet?
Assuming they can find someone who wants to buy $10,000 in Anne & Company shares (in this case, Anne’s mom buys them), the company’s assets and equity both go up by $10,000:
Balance Sheet
Anne & Company Inc.
Notice how Anne & Company sold Anne’s mom a special kind of stock called preferred stock.
There are two major differences between common stock and preferred stock: owners who hold common stock have voting rights at board meetings, while owners who have preferred stock have first dibs on dividends.
Example #2: Paying out a dividend
Let’s say that the owners of Anne & Company (Anne and Alex) want to reward themselves for all the hard work they’ve done over the last few months by issuing a $10,000 dividend.
Anne, Alex, and Anne’s mom each own $10,000 in shares—a third of the company each. So it makes sense that they would each get an equal slice of the pie, right? Not quite.
Because Anne’s mom’s stock is preferred stock, she gets first dibs on the dividend. She’s entitled to $5,000 of the dividend, leaving Anne and Alex to split the rest.
What would that look like on the balance sheet?
Dividends are paid out in cash, so the company’s cash account would go down by $10,000.
At the same time, the company’s retained earnings account would also go down by $10,000, because that’s the account we draw dividends from.
(Remember, companies can either choose to hold on to their retained earnings, or pay them out in the form of a dividend.)
Balance Sheet
Anne & Company Inc.
Example #3: Retaining earnings
Let’s say Anne & Company’s killer app has a really good month in the app store, raking in $50,000 in profits. Instead of paying those profits out as a dividend, they decide to hold onto them in the form of retained earnings. What would that look like on the balance sheet?
In this case, their cash and retained earnings accounts would both go up by $50,000:
Balance Sheet
Anne & Company Inc.
Why does all of this matter?
Any business owner who is serious about growing their business needs to understand equity. If you understand equity, you’ll feel confident bringing in outside investors, working with business partners, and understanding how much your “share” of the business is actually worth.
It also specifically lets you do three things:
Read a balance sheet
Even if you’ve never owned an incorporated business, you deal with assets and liabilities all the time: whenever you buy something, make a credit card payment, or take out a student loan, for example.
The third kind of balance sheet account, equity, is usually a bit trickier to understand for non-accountants. But understanding equity and the many different forms it can take on the balance sheet—preferred stock, common stock, and retained earnings—is crucial if you’re going to own part of a business. If you hold equity in a company but can’t point to it on the company’s balance sheet, you’re in trouble!
Find out whether your company is growing
If your business has strong fundamentals and isn’t financing all of its growth with debt, your owner’s equity should be increasing with time. Understanding equity and being able to track its growth is crucial to understanding the long-term financial health of a business.
Figure out how much you’ll get if you sell your stake in a company
Want to pull out of your friend’s robot lawn mowing business? Understanding equity lets you know how much your stake in a company is actually worth, how much skin you have in the game, and whether it’s worth continuing being an owner or part-owner of a company.
