What is Equity?
Equity is a term used in accounting, in real estate and home-ownership, in investing, as
well as in startup financing and valuation.
The meaning of the term equity is very similar in the various areas where it is used, so
it will be good to review all four of these to get the best understanding.
In accounting, equity is a term that you will find on the balance sheet.
What you own is on the left: assets.
What you owe is on the right: liabilities and equity.
Equity is the book value of the shareholder capital.
Here’s an example.
A company in the manufacturing industry has a machine that it bought for $1 million as
its asset, what it owns.
This asset is financed through a bank loan of $800.000, money that is owed to the bank,
and through equity (shareholder capital) of $200.000, that is owed to Jane, the owner
of the business.
The accounting equation tells you that assets equal liabilities plus equity.
That also means that equity equals assets minus liabilities.
Equity on a balance sheet goes up when a company is profitable: the net income for the year
gets added to equity through retained earnings.
Equity on a balance sheet goes down when the company is loss-making (losses “eat up”
the equity), or when the company pays a dividend to its shareholders.
Equity in home-ownership works very similar to equity on the balance sheet.
What we own is on the left: the house worth $500.000.
What we owe is on the right: $400.000 of mortgage loan from the bank, and the owner of the house,
Jim, has $100.000 of equity in the house.
Equity in home-ownership is what a home is worth minus how much you owe to the bank.
Just like equity on the balance sheet of a company can go up or down, the equity that
you have in your home can go up or down.
If Jim is paying down the mortgage on his house by $50.000, then the amount of the loan
outstanding will decrease and his equity in the house will increase.
If the market value of the house increases, then Jim’s equity in the house will increase.
Remember that equity is what a home is worth minus how much you owe to the bank.
If the market value of the house decreases, then Jim’s equity in the house will decrease,
or even become negative.
Jim will need to have a conversation with the bank to make a remediation plan to get
back to positive equity, or in the worst case scenario Jim might lose the ownership of the
house and the bank will need to take a partial write-off of its outstanding loan.
Investing in equity.
Remember the example of the small manufacturing business that owned a machine, had a loan
from a bank, and equity from one shareholder.
What if we make that a big manufacturing business that owns lots of machines at different sites
totaling $1 billion, has many loans outstanding totaling $800 million that are publicly traded
in the bond market, and has many different shareholders as the certificates of ownership,
the equity, is traded publicly as well.
As an investor, you have the choice of buying bonds (which would have a predetermined interest
rate, and has the machines as collateral), or the choice of buying stocks (which are
perceived as having more downside risk as well as more upside potential).
Invest in debt, or invest in equity.
Equity in a startup company.
How do you put a “price” on what is essentially so far just an idea, that still has to be
developed and will find many ups and downs along the way?
The company does not have any assets, liabilities and equity yet.
The financing and valuation depend on the estimate of the revenue, profit and cash flow
that the business idea might bring in the future.
A good way to learn about startup companies in the tech field is the comedy series “Silicon Valley”.
What happens if the app you are developing turns out to have a great compression algorithm,
you are courted by investors ready to fund you, and your friends and roommates suddenly
become your employees while you become the CEO?
In season one of “Silicon Valley”, landlord/incubator Erlich Bachman has 10% of the shares in startup
company Pied Piper, eccentric billionaire Peter Gregory buys 5% for $200.000, and the
three employees Gilfoyle, Dinesh and Jared get 3% each
in what someday might be a multi-billion $ company.
By my math, that sets the CEO Richard Hendricks up with 76% of the shares in the company.
In subsequent seasons of the comedy series, Pied Piper goes through various rounds of
financing, as well as acquisitions and other ownership changes.
Having equity can be a great thing.
Equity has potential risks as well as potential rewards.
The term equity is used in accounting, in home-ownership, in investing, and in start-up
financing and valuation.
Probably the easiest metaphor to remember is equity in home-ownership: what a home is
worth minus how much you owe to the bank.
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Thank you.