What Does Equity In A Company Mean?
If you're looking for investment, one of the first things to do is establish how much you need and what you're offering as equity.
Not to worry if that doesn't make immediate sense. Basically though, equity is a proportion of your business. So, if you own 100% of your company, you have all the shares and all the equity.
Taking on investors usually means giving away some of that equity in return for a capital injection, and it's crucial to get the balance right! An advisory share with deferred ownership transfer is also possible, if you’re hesitant to give away equity at this time.
Let's run through a little more context to clarify what equity in a company means and why it's a big deal for entrepreneurs and investors alike.
How To Calculate The Value Of An Equity Stake
Accepting an investment for a proportion of shares ordinarily means giving away a percentage of your business to the investor. Equity is defined as the amount of money that those shares are worth, so, if your company is valued at $1 million dollars, then a 20% equity holding is worth $200,000.
Here's a basic way to work out the market value of an equity stake:
take the total value of all business assets
deduct all debts or liabilities
the amount you're left with is an approximate business value
Equity value is the amount of cash that would be left to split between shareholders if the venture closed, you sold all the assets and repaid any debts.
This concept illustrates why equity is the foundation of investment. If an investor contributes capital to a start-up, and the business grows exponentially in size, so too does the value of their shares.
It works differently depending on whether a company is public or private, but the principle is the same.
What Are The Components Of Shareholder Equity?
The main chunk of shareholder equity comes from retained earnings. That means profits you have earned that haven't been distributed as dividends between the owners.
If the company continually reinvests profit into itself and scales up, retained earnings will grow year after year. Many established businesses have higher cumulative retained earnings than the original equity capital contributions made by shareholders.
As a new venture, you're unlikely to have any retained earnings yet, which is why forecasts and market research are so vital to attracting an investor, helping them gauge the future value of any equity they would own if they agree to invest.
Offering Equity Shares To Attract Capital Investment
Entrepreneurs and business start-ups will often want the support that working with top business mentors brings, in order to get an edge over the competition!
If your strategy is also to attract investors, ideally professionals with a strong presence in your sector, you'll need to think about a fair percentage for an investor.
There isn't any one-size-fits-all approach here because the proportion of the business you offer up depends on:
● how much investment you're looking for
● projected profits and investor returns
● your industry, sector, and market niche
● the level of involvement you want your investor to have
● your experience and brand reputation
For example, if you need a considerable investment to launch a product that needs extensive R&D, an investor probably isn't going to contribute without having a decent stake in the business.
But, if the investment requirement is modest in relation to the existing company valuation, they'll often accept a smaller share.
The best way to think about it is to clarify what you're trying to achieve, how much risk you're asking an investor to take on, and how likely the business will deliver attractive returns.
Begin by working out an indicative business valuation, and spend plenty of time producing detailed forecasts. You'll find it easier to answer those tricky questions under the pressure of an investment pitch! Read here about what advisory board members do.