The exact meaning depends on context, but equity in accounting generally refers to the value of an ownership stake.
For example, when people talk about the “equity” they have in their home, they’re referring to the portion they own outright. If your house is worth $400,000 and you owe $300,000 on the mortgage, you’d keep $100,000 if you sold and paid off the loan because your “equity” is $100,000.
In this article, we’ll cover what equity means, how to calculate it, and why it matters for your business.
Common Types of Equity in Accounting
Since there are so many different varieties, “equity” can be a confusing catch-all phrase. Here are a few of the most common examples:
- Owner’s Equity: A sole proprietor or LLC founder’s stake in the business.
- Partner Capital: Each co-owner’s share in a partnership.
- Shareholders’ Equity: If a corporation issues stock, shareholders get a portion of the profits, and if the company shuts down, their share of liquidation proceeds.
- Treasury Stock: Shares of a company’s own stock that it repurchased from the open market or shareholders.
- Retained Earnings: Cumulative profits kept in the business instead of distributed as dividends. Even though the cash may be spent on growth, it still ultimately belongs to the owners.
- Additional Paid-In Capital (APIC): When an investor buys stock above its market value, the difference goes into APIC. The extra amount isn’t a loan; it’s part of the owner’s stake.
Book Value vs Market Value
To make things even trickier, there are two different kinds of “value” accountants may be referring to: book and market.
Book value works similarly to personal net worth. Add up a business’s assets, subtract liabilities, and the remainder is book value. Anything from accounts receivable to cash, property, and real estate is an asset, while unearned revenue, loans, and accounts payable are liabilities.
| Unearned or “deferred” revenue is an important concept for businesses that charge up-front for services they deliver over time. Learn how your ability to raise funds can be impacted with our cash vs accrual accounting guide. |
“Market value” refers to what your business may actually sell for, and depending on how you’re doing, could be more or less than book value. Privately held companies typically sell for revenue multiples between 2-10x, while a public company’s market value refers to the fair market value of all outstanding stock.
Equity Calculation Examples
Calculating a public company’s market value is simple.
Market Value = Shares of Stock x Price of Stock
For example, Amazon has ~10 billion outstanding shares, which sell for $230 each, adding up to a total market value of $2.3 trillion.
Similarly, the book value formula is pretty easy as well.
Equity = Assets – Liabilities
Let’s say you own a small bakery. Between your ovens, mixers, and equipment, you’ve got about $60,000 worth of gear. Add in $20,000 cash and another $10,000 worth of flour, sugar, and other supplies, and your total assets come to $90,000. On the other hand, you owe the bank $50,000 on a loan, and another $15,000 in outstanding invoices to suppliers: that’s $65,000 in liabilities.
In this example, you’d have $25,000 in net equity.
In practice, accountants record and calculate equity on balance sheets, like this:
These can get pretty complicated. They’ll typically include at least two years of data, so stakeholders can see changes over time, and are broken out into any number of categories that may be relevant to a business. For detailed information, read our comprehensive guide on the equity accounting formula.
Positive vs Negative Equity
When equity drops below zero, it means owners or shareholders owe more than they own. In other words, it’s “in the red.” Negative equity can happen if a business has too much debt, or if profits are being pulled out instead of being reinvested in growth.
Real World Use Cases
Equity isn’t just an accounting term. It shows up in real decisions that shape your business’s future.
- Getting a loan: Banks and lenders want proof you can cover your debts. Strong equity, as well as good personal finances, makes you less risky.
- Attracting investors: Venture capitalists, angel investors, and even friends and family may look into your equity to judge whether you’re building real value. They want to know what they’re buying into.
- Preparing for an exit: If you plan to sell, equity is the starting point for negotiations. Acquirers will look at your current balance sheet, but also how your revenue and equity have grown over time.
- Voting rights: Selling stock, or an ownership stake in your business, gives others influence over your company.
- Bringing in partners: Equity decides ownership percentages. Whether you’re adding a co-founder or giving key employees equity stakes, this is how you define “who owns what.”
In short, lenders, investors, and partners use equity to measure the value your business creates as well as what you stand to gain if you decide to sell.
The Bottom Line
Equity can mean quite a few things in business. But whether you’re applying for a loan, pitching investors, or planning an exit, understanding this key accounting concept helps you stay in control of your company’s value.
Want clarity on the bigger financial picture? Or maybe you’d prefer to let someone else handle the nitty-gritty details of accounting? Reach out for a free consultation. We’d be delighted to help.
