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As accountants, we are naturally well-versed in the industry lingo. For those running their own businesses, it can sometimes seem like a whole other language. It’s why we began our Understanding Accountancy Terms FAQ series.

In this article we continue our quest for clear accessible accounting by looking at what equity means for businesses.

What is business equity?

If you own a business, equity is basically the net worth of the business. To calculate equity, you need to know the value of a business’ assets and liabilities.

Assets

Assets are things that the business owns which have a value. These can include:

Liabilities

Liabilities are something that you need to pay in the future. These might be:

So where does equity fit into it? Well, there’s a formula for it:

Equity = assets – liabilities

The equity of a business is ‘what’s left over’ once the liabilities are deducted from the assets. In this sense, equity indicates the value of a business on paper.

It’s important to remember though, that a business usually isn’t worth just the equity on the balance sheet. There can be much more value not included, such as the company’s potential growth, market opportunities or the value of the customer base that the company generates.

What does equity mean for small businesses?

Think of equity as the valuable bit of the business that’s left over from the assets once the liabilities are deducted.

The more equity, the more valuable a business is. Businesses can sometimes use this as leverage for investment.

Selling equity to raise funds

When you own shares in a business, then you own equity and a share of the profits. If the business does well, then the profits grow, and so does the equity value.

A limited company which needs to raise money to finance growth might consider selling equities (shares) in the company.

What’s in it for the investor?

The investor gives the business money for shares in the hope that their value will increase. Investors can then earn money on equities either by:

Receiving dividend payments from the business

Owning shares entitles the shareholder to a proportion of the profits. These are paid as dividends, and are worked out in relation to how much of the business the shareholder owns.

A yearly tax-free Dividend Allowance allows someone to receive up to £2,000 of dividend payments each year.

Read our article about Dividend Tax to learn more about the Dividend Allowance, tax thresholds, and tax rates.

 

 

Selling their shares at a later date

If the company grows and becomes more valuable, it means that the equity they own increases in value, too.

They can sell their shares for more than they paid, and make a profit (called a capital gain – read our article about Capital Gains Tax to learn more).

Equity risks for businesses and shareholders

There are risks involved for both sides.

Investing is a risk

Like any investment, buying shares in exchange for equity carries a risk. The business might not perform as planned, so the value of the equity might decrease.

It changes the business

For a business, selling equity means that the original owner(s) must share the profits with the other shareholders. It also means that ownership is shared too, which can give shareholders a say in big decisions.

For instance, if you wanted to sell your share of the business then the other shareholders might have to agree to this. It can make it more difficult to make decisions or changes later on.

accounting services for limited companies

Putting a shareholder’s agreement in place makes it clear what shareholders are entitled to, and what rights and responsibilities they have regarding the business.

Some businesses create different classes of shares (sometimes known as alphabet shares). Our article about types of share classes explains this in more detail, but different share classes can be assigned different rights, such as:

Talk to one of our team about the online accountancy services we provide. Call 020 3355 4047, or request a call back when it’s convenient for you. You can even grab an instant online quote.

About The Author

Beth-Anne Bruce

I'm an experienced and fully AAT and ACCA qualified accountant, who is enthusiastic about helping business owners succeed. I also love cooking and needlepoint (at different times!). Learn more about Beth.

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