What is equity in business? It is a question whose answer every small business owner would do well to understand. 77% of small businesses rely on personal savings to get off the ground, and more often than not, those personal savings are life’s savings.
When everything you own is on the line, equity must be a term you become intimately acquainted with.
What Is Equity?
Let’s begin with a simple definition. Equity is a term that varies according to context, but in the pure financial sense equity is the difference between what your business owns (your assets) minus what you owe others (your debts and liabilities).
We can look at it as a basic accounting formula: Equity = Assets – Liabilities/Debt.
So if assets are anything your company owns (cash, property, inventory, computers and other office equipment, motor vehicles or the cash value of any of those products), and your liabilities are any debt the company has incurred (car notes, mortgages, equipment costs, accounts payable, payroll, etc), your equity as the business owner, and thus legally entitled to all assets and responsible for all liabilities, is measured by the relationship between the two.
This formula can be rearranged to determine corresponding total values; Assets = Liabilities + Equity, or Liabilities = Assets – Equity, and makes a good foundation for a proper balance sheet.
Based on this limited financial interpretation, you might say, “This isn’t rocket science.” And it’s not. It is, however, a foundational concept. As a valuation firm, we come across all types of financial instruments that are more complex than the typical simple equity instruments you may be accustomed to like common stock in a corporation and units in a LLC. More often, we’re evaluating more complex instruments that may have characteristics of both debt and equity and their nature could even change depending on the evolution of the company.
Armed with this baseline understanding of what equity is, we can evaluate more nuanced forms of investment capital, and you – as a manager or investor – can consider the most useful and lucrative ways to use it to maximize the value in a business.
Different Types of Equity
Even more familiar to most people than business equity is home equity. This is defined as the value of the home minus the amount owed on the mortgage. The idea of “house flipping” is predicated on building home equity. If a homeowner borrows $80,000 to buy a $100,000 house, the homeowner now owns $20,000 or 1/5 of the equity of that home.
When plugged in our equity equation it looks like this:
Equity ($20,000) = Assets ($100,000 house) – Liability ($80,000 mortgage)
This is a crucial piece of information if that homeowner hopes to maximize their investment. If the value of that home increases to $200,000 thanks to market gains, improvements and/or renovations, while the mortgage remains at $80,000, they see a profit of $120,000 which triples their equity from 20% to 60%!
Equity ($120,000) = Assets ($200,000) – Liability ($80,000)
From a business perspective, replace the mortgage mentioned above with the liabilities incurred in operating a business and the net result of assets less liabilities is stockholders equity. This is also known as shareholder’s equity.
Investing in a company’s stock is essentially purchasing a small slice of the company itself, and if that company flourishes, so do stockholders according to their relative ownership interest.
On the flipside, there is such a thing as negative equity. Similar to being “underwater” on a home, negative equity means the company’s liabilities are greater than its assets. This is also referred to as balance sheet insolvency, and such a situation is viewed by investors as a high-risk investment. The company will need to payoff liabilities at a higher rate than they are incurred to shore up their balance sheet. Note that this is a different scenario than illiquidity, which means that a company lacks the resources available to meet near-term obligations. Not being able to pay your bills because your short on cash (illiquidity) is different than owing more than you own (insolvency).
Another form of equity is brand equity. When determining the worth of a company, particularly with larger companies, the assets considered may be both tangible and intangible. While tangible assets like property are relatively easy to place value on, intangible assets like reputation or brand also contribute to a company’s worth. This brand equity determines the value of a brand relative to a generic or store brand of the same product.
For example, if soft drink lovers prefer the taste of a Coca-Cola which is $2.00 per 2-liter bottle to the store brand cola, which is $1.00 for a 2-liter bottle, then Coca-Cola could be said to have a brand equity of $1.00. Brand equity can only be built from years of successfully servicing a loyal customer base, and thus it is rarely considered in the context of startup valuations. However, we frequently value brand, trademarks and tradenames as well as other intangible assets when a company acquires another company as part of a purchase price allocation (this requires a valuation per the FASB’s ASC 805 fair market value guidelines).
What is Equity Financing
Equity financing is a way of financing operations and potential growth at a company that carries different characteristics than taking out a loan or debt financing.
If the company shows promise, but cannot obtain traditional debt financing – or chooses not too – equity financing offers businesses the opportunity to attract new investors by offering stock or shares of ownership in exchange for capital. The alternative, debt financing, is characterized by using that same investor capital with the intent of repayment at a point in the future. It’s a critical difference, and a decision that shouldn’t be made lightly.
While equity financing carries no obligation to repay that invested capital, the financing comes at the price of giving up a certain percentage of the company. For entrepreneurs who dedicate their working hours to their team and customers, relinquishing equity presents a significant tradeoff. Additionally, entrepreneurs should make sure that potential investors make good business partners as the investors often have significant influence over the business going forward.
Using Equity to Grow Your Business
When to Use Equity Funding
Having established what equity is and the different types of equity available to business owners, let’s examine how we can use our newfound knowledge to expand our business.
When it comes to raising capital for business operations and expansion, chasing investors is a tactic used by companies both large and small. There are basically three types of investor funding available to business owners; equity, debt and instruments that carry qualities of both, like convertible debt. For the purpose of our discussion, we’re going to consider equity funding.
As we learned earlier, pursuing equity funding means you are offering a stake in your company in exchange for immediately available capital. The fact that the money invested doesn’t have to be paid back makes it an attractive option, but it’s not right for every situation. So, under what circumstances do we use equity funding for maximum effect?
As A Lifeline
Not every business begins generating revenue immediately on launch. Some startups; particularly in the software-related industries, may operate with no actual income for literally years on end.
If your company requires an infusion of cash before it reaches a point of profitability, equity investments may be the only sensible option.
Loans can be used for business funding. However, banks often want some form of collateral, particularly for startups. Many early-stage companies are left facing a conundrum: How to get capital when you have nothing of value to secure that capital.
Without something valuable to offer lenders, the only avenue left may be to parcel off equity shares in their business to investors who see the potential for a good – even outstanding – return on their investment.
When Bootstrapping Isn’t An Option
Everyone loves a good rags-to-riches story, but starting a restaurant in the kitchen of a studio apartment may simply not be possible. Even when the idea is viable, most investors will need to see some form of the finished product before agreeing to fund a given project.
Drawbacks of Equity Investment
Equity investment capital sounds like a compelling idea; however, even though the money doesn’t have to be paid back it still comes at a price.
Equity Investment Limits Your Options
In terms of the future of your company, equity investment means giving up a certain degree of control as to its direction. Investors will often view the company from a different vantage point than managers. Then there’s the fact that the actual people deploying capital probably have their own investors to answer to. Their time horizon could look different than that of management. And, at the end of the day, they have to stay focused on the prospect of an outsized “exit” in the form of a sale to a larger company or an initial public offering (IPO).
This means that before accepting their money, the wise business owner will want to ensure that their vision for the future of the company matches that of their potential investors.
Big Investors Expect A Big Return
If most entrepreneurs could walk into a bank and get a loan, they probably would. Unfortunately, banks are extremely risk-averse, and will only provide loans they are confident will be paid back.
Equity investors take risks banks are simply not willing to, and they do so on the promise of larger rewards when the company’s objectives come to fruition than a loan provider would demand.
There Is High Competition For Equity Investors
There are vastly more entrepreneurs seeking funding for their ideas than there are equity investors looking to cut a check in anticipation of the next big thing. This means that much like landing a spot on a professional sports team or being the star of a top-rated TV show, these spots represent only the very top percentile – the upper echelon, if you will – of the opportunities for people seeking funding.
Only the most prepared and motivated of entrepreneurs with the most visionary, high impact projects will walk away with that equity funding secured.
Equity Financing Takes Time
Finding the right investor can take months if not years, and then there is the inevitable legal red tape that may also take months to cut through. So, if a quick turnaround is needed, equity funding may not be the tactic to utilize.
Once Equity Is Given, It’s Gone
It is exceedingly rare for entrepreneurs to reclaim equity once they’ve given it up. So, once an investor’s money has been accepted, that investor will likely be part of the landscape of that company in perpetuity from that point forward barring an equity buyback or similar purchase of the investors equity interest. Therefore, it is extremely important to know who you’re doing business with before entering a contract with them.
Building Equity Starts With Understanding It
It’s hard to underestimate the importance of the equity component in business financings and transactions. Investors, entrepreneurs, and financiers should be diligently considering how a decision will affect the equity on their balance sheet, their portion of a deal structure, or the potential for dilution in their equity shares.
Consider, too, how the interests of your fellow equity holders align with your own.
Finally, there will be points along the way where you need to know the fair market value of equity – either at an enterprise or per share level. A proper valuation is necessary at these junctures to provide clarity heading into a transaction, an issuance of options, an equity round raise, or another significant financial milestone.
We’ve performed thousands of valuations. Can we help your company? Drop us a line.