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quity is a word you hear often as the owner of a growing business. It's an essential factor in attracting investors and helps you figure out how much your business is worth.
But what is equity, exactly? Here's what you need to know about this important business concept.
Definition and explanation of equity
Equity is the total value of a business's shareholder-owned assets. Assets include the total value of everything your company owns, including cash and non-cash valuables, such as equipment, real estate, and inventory. Liabilities are financial obligations, including longer-term debts and near-term accounts payable.
Types of equity
All equity represents ownership of a business, but different types of equity work in different ways. Here are the three categories you need to understand.
Common equity is the total value of ownership shares in a company minus any priority shares. Priority shares belong to investors whose agreements give them preferred access to distributed earnings. If a business doesn't offer priority shares, all equity is common.
Common equity holders typically have voting rights when a decision goes to shareholders. One common example is when the company votes for the board of directors.
Common equity shareholders usually also receive dividends when the business pays them out. When a company generates profits, its leaders may decide to distribute some of those profits to shareholders as dividends.
Common shareholders receive their dividends based on the company's profits. The more profitable the business is, the more each shareholder receives in dividends.
Preferred equity is a portion of company ownership that includes a priority claim to company assets. If the company liquidates its assets—in other words, converts them to cash—shareholders with preferred equity will receive their share before those with common equity.
Preferred shareholders usually receive fixed dividends, meaning the amount is the same regardless of profit levels. Businesses also pay preferred shareholders before common shareholders. If the amount of these dividends equals or exceeds profits, common shareholders don't receive payment.
Retained earnings are the portion of a business's profits that the business reinvests in itself instead of distributing to shareholders. Companies use retained earnings for a variety of growth-generating activities such as paying down debt, funding research and development, or buying equipment.
Retained earnings are important resources for a growing business. They allow the company to drive growth without relying on loans or investors. In some cases, they may also serve as a cushion against future losses.
However, most companies only retain earnings if they believe the money can generate a worthwhile return on investment. If not, a business will often distribute those earnings to shareholders.
Importance of equity for small businesses
Equity has the power to drive a business's growth, both in terms of worth and investments.
How equity affects business value
Equity makes up a significant portion of most small businesses' worth. A common way to calculate that value is to add the value of equity and debt investments and subtract any cash. The more equity your business has, the more attractive you are to investors and potential future buyers.
Role of equity in attracting investors
Growing businesses secure funding by selling shares or taking on debt. Investors usually demand a higher rate of return from shares, making shares more expensive than debt in face-to-face comparison.
However, as a business takes on more debt, its risk of default increases because it owes more. Equity allows a business to "court" investors by offering ownership shares. The more ownership shares you have, the more you have to offer an investor.
Equity financing options for small businesses
There are multiple ways of using equity to attract investors. One gathers multiple small investments from many investors, while the others target fewer larger investors.
Equity crowdfunding lets newer businesses attract shares by offering a certain number of securities to individual investors. Most equity crowdfunding efforts take place via an online platform, where investors can browse options and choose the investment target that suits their preferences.
Equity crowdfunding is different than most traditional securities-based capital-raising efforts, which typically depend on large investments from a small number of investors. Equity crowdfunding lets a business accept smaller investments from more investors because the investor pool is much broader.
Equity crowdfunding benefits smaller companies because they can source the required capital without giving away too much control. Each investor has a smaller share of ownership and thus has less of a stake in the company. Therefore, company ownership and any larger investors retain more control.
Angel investors are individuals or groups that fund newer businesses in exchange for equity or convertible notes. Convertible notes, also called convertible bonds, are debt products that an investor can convert into equity when more equity is available.
Besides convertible notes, angel investors can receive convertible preferred stock or a direct equity stake. Those with preferred stock tend to be board members and contribute to company operations in that role. Direct equity investors have up to a 30% stake in the company and participate directly in management.
Venture capital is an equity investment from a fund that includes multiple individual investments. Like angel investors, these funds receive ownership stakes commensurate with their investments. Unlike angel investors, who invest their own money directly, venture capital funds source investment dollars from limited partners.
Venture capital funds typically operate under the leadership of general partners, who select investments and oversee fund distribution. General partners often serve as board representatives, advisors, or managers for the companies their funds invest in. They also manage the fund and select investment opportunities, usually receiving a management fee plus a larger share of returns in exchange for their services.
One of the most important things a small business owner can do for their growth is learn how to manage equity effectively.
Equity allocation and distribution
At the beginning of a company's lifetime, founders own 100% of its equity. If there are multiple founders, they may split the company's starting equity equally or distribute it based on who invested more time and money in the company.
Founders also need to decide how many shares to reserve for investors and what percentage an individual investor can receive. Investors with a higher percentage of equity will have more say in the company's operations. Majority shareholders—those who own 50% or more—have the right to participate in day-to-day decision-making.
Dilution and its implications
Distributing equity to shareholders results in dilution—a reduction in each share's value. For example, suppose two founders each have 25 shares of stock in a company. Those 25 shares give each person a 50% stake in the company. So, each share conveys 2% ownership in the company.
Imagine the founders issue 25 shares of stock to an angel investor. Now, there are now 75 shares in total. So, each share is now worth about 1.33% ownership.
Because dilution reduces each person's percentage of ownership, it also reduces their influence. For this reason, most companies will only allow a limited amount of dilution.
Equity agreements and legal considerations
Any time a company distributes ownership shares, it relinquishes partial control and selected legal rights to the company. Shareholder agreements, also known as equity agreements, provide details on how this works for both sides.
Detailed equity agreements are important for protecting the company's legal interests. They need to accurately describe what the new shareholder receives in exchange for their investments and any responsibilities that go along with it.
Summary and key takeaways
Equity is the ownable value of your business. Some have preferred access to that value based on how much they've invested and the terms they invested under, but all equity represents part of your company.
For investors, equity is the right to share in your future profits and sometimes to weigh in on how you build those profits. It's important to distribute and allocate equity strategically and with the right documentation. Then, everyone understands their rights and responsibilities.
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Novo Platform Inc. strives to provide accurate information but cannot guarantee that this content is correct, complete, or up-to-date. This page is for informational purposes only and is not financial or legal advice nor an endorsement of any third-party products or services. All products and services are presented without warranty. Novo Platform Inc. does not provide any financial or legal advice, and you should consult your own financial, legal, or tax advisors.
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