New business owners sometimes have a hard time understanding equity. Most of the time, people don’t get into business because they want to do lots of financial accounting. They want to earn money by providing a great product. Of course, understanding your financial situation is a critical part of procuring those profits. Without a clear picture of how much value your business has, it can be difficult to keep it running and providing those great products.
The key to understanding equity better lies in understanding two related terms: assets and liabilities. Your equity is the result of an equation: Equity equals assets minus liabilities.
Assets: More Than Profits
What makes up the assets of a business? First, there’s a part of the initial investment. It’s important that we only refer to part, because usually, the initial investment doesn’t come from only one person or entity. The business owner often does put in a chunk of their own money. That part is one of the business’s assets. Investment by venture capital firms is also part, but it’s separate from that of other owners. Loan funds from banks are not an asset, but rather a liability.
As the business grows, it acquires more assets. That includes fixed assets such as real estate and production equipment. The company can also own more liquid assets such as inventory and cash accounts. The company’s retained earnings after interest and taxes become part of the assets.
Assets can even include intangibles such as the company’s customer base and it’s goodwill among them. Your company’s brand can become one of your most important assets. Accountants can put specific monetary value on many of these intangible assets. They will show up on your balance sheets.
Liabilities: Everything You Owe to Someone Else
As mentioned before, not all the money that goes into your business is yours to keep. Most businesses need some amount of start-up capital. Most small or new business owners don’t have those kinds of financial resources on hand. They have to appeal to investors such as venture capital firms or banks. In the latter case, that means taking out a loan that has to be repaid at some future date. The value of any such loan is a deduction from the value a company’s assets to determine equity. That money belongs to someone else. Until you pay it back with interest, a proportion of the value of the business also belongs to someone else.
Those aren’t the only kinds of liabilities, of course. Insurance payments, accounts payable, depreciation, and salaries owed all fit the bill.
Understanding Equity at The End of the Equation
An owner’s equity in the company is their share of all the assets minus the value of the liabilities. That’s whatever the company owes investors or vendors, and anything else that can decrease the value of the assets.
That brings up another important point. Each owner’s equity corresponds to their share of the company, or in other words, how much stock they own. In the case of a sole proprietor, that’s not an issue; 100% of the equity belongs to them. Stockholders, though, whether public or private, each own a proportion of that equity.
That includes the case of Venture Capital investors. Often, they will invest to start up the business in exchange for a percentage of shares in the company. That makes them owners of a part of the company’s equity.
Understanding Equity and Its Value for the Future
What can you do with equity?
This is a matter of company strategy. Companies can grow to immense power by reinvesting their equity. The Ford Motor Company under Henry Ford himself was a classic example. The phenomenal growth of Amazon in our time is another. They used their equity to expand operations, grow their customer base, increase efficiency, and hire many, many more people. This leads to an acceleration in equity growth down the road. There’s a tradeoff, though.
One of the alternatives is to pay dividends to stockholders out of retained earnings. Owners can draw from the company’s equity as needed or desired, within financial rules. Investors usually expect to see such returns from their investment. That means that the balance between reinvestment and dividends is important. Drawing too much from equity can put a damper on business growth. Reinvesting too high a proportion of the equity for too long can test the patience of the investors.
MadCap Ventures knows the investment needs of businesses based on great ideas. Many such ideas get passed over by larger VC firms looking for a big payout. We know that lots of smaller payouts can be more sustainable in the long run. If you’re looking for a balanced boost to provide your new business with more equity, get in touch with us!