How Does Equity In A Company Work?
Equity is a financial measure of the value of company shares, and there are countless ways to approach it!
Your equity stake measures a range of metrics, such as:
The valuation of the entire company
the cost of inventory
the total value of all assets held
Businesses give away equity shares for a range of reasons. They might offer equity as non-cash employee compensation or pass over a chunk of shares to an investor in exchange for a financial contribution.
Here we'll explore further to answer the question of how equity in a company works and examine the key players in running a business.
The Link Between Business Ownership And Equity
Understanding the definition of equity in a company is crucial, since if you plan to dilute your ownership, you need to have a clear idea about how much those shares are worth.
Company structures typically work like this:
Shareholders hold a proportion of business ownership.
Directors run the company on behalf of the shareholders, reporting back at Annual General Meetings (AGMs).
Owners of private ventures can own 100% of their shares or might give away a proportion of equity for reasons we've considered.
Individuals can also invest in shares of public enterprises and thereby become partial owners.
Therefore, if you decide to pitch for investment, giving away equity in return, your investor will now own a proportion of your company.
Many start-ups also offer an advisory board member's role to their investors, along with special advisory shares. These are often different from the shares offered to regular investors and employees, and can be used as a way to pay investors back.
That means the investor acts as counsel, advising directors and owners to help with decision-making and developing a strategy for growth.
How Does A Shareholder Make Money From Equity?
Any investor will want to see a business valuation and projected performance to establish whether the equity shares will be worth the investment you're looking for.
There are two main ways they expect to receive a return, depending on the structure of the investment:
Dividend Payments
When you distribute net profits as a dividend, that income is split between your shareholders according to their equity stake.
For example, if you declare a $5,000 dividend, and your investor owns 20% shares, they'll get $1,000.
Capital Appreciation
The goal is that your business grows and becomes more valuable as the turnover increases. Each share has a nominal 'book' value, usually $1. So, you might have 100 shares, with each one worth 1% of the business.
That value is different from the market value or what another investor would be prepared to pay to buy the shares from the existing owner. Let's say your business is valued at $1 million, and you give an investor the same 20% stake. Those shares are worth $200,000 in total.
In five years, if the business grows in value by 30%, it's worth $1.3 million, and your investor could sell their shares to make a $60,000 profit.
How Much Equity Should I Offer An Investor?
Deciding what equity to offer is a decision that will affect your business for the long term and requires careful thought and planning. Investors take a risk since there isn't a guarantee that a business will succeed, pay out dividends, and increase in value.
Therefore, you need to balance your equity offer against the investor's chance of losing their money. The lower the risk, the lower the anticipated return, and the less generous you'll need to be!
For higher exposure investment projects, an investor will need a sufficient equity stake and respectable projected returns to part with their cash.
It's vital to go into any investment pitch with a complete set of figures, forecasts, and risk analyses to demonstrate what you're offering and help your investor make an educated decision about the viability of the investment proposition.