By Ashley Preen
July 27, 2021
Perhaps no word elicits more confusion in the financial world than “equity.” Although the dictionary has several specific meanings for the word, those meanings have changed and morphed. Equity means one thing in accounting, something different in the stock market, and also something else in real estate!
In this article, we’re going to take a deep dive into the subject of equity in financial contexts, all its shades and nuances, and match those up with real-world examples so that you can finally and definitively lay the word equity to rest and really know what it means!
The source of the word equity means “quality of being equal or fair, impartiality.” And although the plain-English word still means that, the financial use of it might appear to be a far cry from what it once meant.
But if you think about it, owning what is truly yours is fair and just. In a financial context, equity is all about showing who owns what and making sure it’s fair.
By the 1620s, the word had expanded to also mean “an equitable right, that to which one is justly entitled”—like shares in a company, or a portion of a home.
We’re going to keep things really simple. One of the most frustrating things about financial topics is that they seem to be written in such a way that only insiders can understand. That’s not cool. So, here’s an explanation for the rest of us:
In its most basic form, in the investment world, equity means shares in a company. Back in the day, shares were purchased by screaming stockbrokers from the floor of the London Stock Exchange (LSE) or the New York Stock Exchange (NYSE). These days, people buy them from the comfort of their own homes or their offices, using programs designed specifically for it. There are even stock market apps for mobile, like Robinhood or Acorns, which allows you to buy “micro-shares”.
When a company’s shares go up, you make a profit.
When people own shares they own equity. Another word for shares is stock.
Equity = stock = shares.
Owner’s equity is basically what you, as the owner of your business, truly own in that business, after paying off your debts and liabilities.
Remember, the basic meaning of equity in finance is ownership.
The owner’s equity can be represented by looking at the accounting formula in reverse.
Owner’s Equity = Assets – Liabilities
Another way to phrase this is:
Owner’s Equity = Net Assets
When you’ve paid all your debts, what you have leftover is the owner’s equity.
Owner’s equity is only used when talking of sole proprietorships. Corporations use the term “retained earnings” and partnerships use the term “partners’ equity.”
But, on a high level, it comes down to the same thing: What’s leftover that the owner(s) can get their hands on after all the chips have fallen!
Equity financing is a way for companies to raise money by selling off “partial ownership” of their company to outside investors.
The term equity financing usually refers to companies that are not yet listed on a public stock exchange such as the LSE or the NYSE.
Such companies are called private companies.
We explain the term equity financing further in the next section.
Startups—and, in particular, tech startups—usually require a lot of capital to stay competitive and launch their products fast enough. The most popular way to do this is to raise funding. The capital they raise falls under the category of private equity and is part of an equity financing strategy where funds are raised from outside sources before the company has completed its final product.
Private equity is not listed in a public stock exchange. This has several implications.
The first is that even though investors might be offered “shares,” the concept of these shares works slightly differently to publicly traded shares. Publicly traded shares, which means shares in companies like Google or Apple that you can buy on a public stock exchange, go up and down in price, depending on how the company is doing. When a share goes up, shareholders can sell their existing shares at a profit.
Also, shareholders of public companies can sometimes earn dividends from a company’s earnings, although this is not mandatory.
Things don’t work that way with private equity.
It’s true that UK Private Limited Companies can also have shareholders and that these shareholders earn dividends, but this is a slightly different concept than that of private equity as it is commonly used today.
Investors in startups typically invest for the long haul and earn no dividends. Even though they are given a “share” in the company (i.e. an equity interest), these are not publicly traded shares and so one cannot determine if the price of the share is “going up” or “going down.” Private equity investors usually expect a payout several years down the line, when the startup makes its first Initial Public Offering (IPO)—the first sale of shares to the public.
An IPO can raise a tremendous amount of capital for a company, and the initial investors will usually come out in clover after that. By then, the private equity game is over and the company is officially a public company, selling its shares in the public stock market.
Equity (stocks and shares) is not the only way a company can raise funds to carry out its duties. The company can also sell “debt.”
Selling debt? How does that work?
It works primarily in the form of loans. And the principle behind it is that the loaned amount will be paid back with interest.
But there are other instruments that can be used to raise capital which is, technically speaking, also debt instruments.
The first of those instruments is called a convertible note. This type of debt is usually offered early in the startup’s life. When raising funds from friends and family (or angel investors, which are usually also friends and family), the startup will often sell a convertible note to them.
A note is defined as “a written promise to pay a debt”. And a convertible note is a type of note that can be converted into equity (company stock) later on in the company’s life.
Another form of debt equity is called venture debt. This type of debt financing usually occurs when a startup has already made a bit of progress and already has some venture capitalists on board who are putting the pressure on to make the company profitable. When this happens, other investment firms can come along and offer a straight loan which they are confident will be paid back with interest because of the other venture capitalists that have an equity interest in the company.
There are very many technical terms to describe the types of certificates and/or bonds the company can issue to acknowledge that it has “sold” some debt and that it is committed to paying interest on that debt. But the main point to understand is that private companies can raise capital in two primary ways:
The Debt-to-Equity ratio shows how much of a company’s capital has been raised by debt versus equity. A company that has a high D/E Ratio is said to be “highly geared” or “highly leveraged”.
The D/E Ratio shows what would happen if debt collectors came calling tomorrow. A high D/E Ratio is not necessarily a bad thing, depending on the industry. Companies in highly competitive fields would do well to keep the D/E ratio low, because competition could wipe out gains quickly, forcing debts to be paid. But companies that have a monopoly on services, like telecoms and electricity providers, can operate in a “highly geared” manner because people depend on their services and so must pay for them every month.
Remember, depending on whether you’re a sole proprietor, small business, or corporation, owner’s equity can be expressed differently.
To keep things simple, let’s just say that shareholders’ equity is the same as owner’s equity. Single-person companies can use owner’s equity while multi-person companies can use shareholders’ equity. (I know, I know, that’s not 100% correct, but we’re just trying to keep things simple.)
And the formula for owner’s equity is:
Equity = Assets – Liabilities
Essentially, the shareholders’ equity ratio shows how effective the shareholders’/owner’s equity has been at generating assets.
The formula for shareholders’ equity ratio is:
Shareholders’ Equity Ratio = Shareholders’ Equity / Assets
A high ratio shows that a large portion of the company’s assets have been attained through shareholder funds and not through debt financing. If the ratio is low, it shows that the company has used debt, primarily, to generate assets.
Just like a fish market sells fish and a meat market sells meat, an equity market sells—can you guess?—equity! In other words, it sells stock, and the more common term for an equity market is “the stock market.”
The equity market is made up of exchanges and over-the-counter (OTC) markets.
An OTC is like a decentralised exchange. It is conducted entirely electronically and without the help of intermediaries such as brokers. Traders buy and sell amongst each other through their computers. One of the key requirements of an OTC market is that it is liquid, meaning that it has sufficient trade volume to carry out trades easily. For example, if someone wants to sell 10,000 shares of XYZ at £5.00 a share (a total of £50,000) but the other buyers in that market rarely buy or sell over 100 shares at a time, then the market is not very liquid and its trading volume will below.
Just like in investment, equity in real estate means ownership.
In real estate, home equity means “how much of the home someone actually owns.” That might sound weird if the person has bought the home and it belongs to them. But homes are typically purchased through a home loan, so a home actually belongs to a bank until it is fully paid for.
Let’s say a house costs £100,000. A new homeowner puts up 20% of the value as a deposit, and then borrows the remaining 80%—or £80,000—from the bank.
The bank is said to have a lien on the house in the amount of £80,000.
A lien is the right of a creditor (someone lending money) to take ownership of property that has been used as collateral for a loan. In our example above, the house has been used as collateral for a loan of £80,000.
On the date of purchase, the owner’s home equity is £20,000 because that’s the amount of money they put into the purchase—it is how much they actually own of that house, 20%
Let’s imagine that the owner pays off £10,000 on the mortgage loan (we’ll skip interest to keep things simple) so that the owner’s total amount invested into the property is now £30,000. Well, if the house’s market value is still £100,000, then the owner’s home equity is now $30,000.
But, let’s say the house goes up in market value to £110,000.
The formula for home equity is:
Home Equity = Market Value of House – Liens
The homeowner still owes £70,000 on the house—the bank’s lien on the house. And the house is now worth £110,000. Our equation can be rewritten as:
Home Equity = Market Value of House(£110,000) – Liens(£70,000)
The homeowner’s home equity is now £40,000, even though they have only paid £30,000 for the house.
The tricky thing about home equity is that it isn’t particularly liquid, which means it’s not easily convertible into cash. And, although the house in our example above might have a market value of £110,000 according to a recent appraisal, it doesn’t guarantee that the house will sell for that much.
But that home equity value can nonetheless be used as collateral for a second loan. This second loan is called a home equity loan or a second mortgage.
By using the home equity value as collateral, a person can refinance their existing house or take out a second loan for another house.
The simplest meaning of equity is ownership. Whether in real estate or investment or in your business, when you have equity, you own something.
Equity opens the door to numerous ratios and mathematical formulas that finance professionals such as accountants can use to determine profitability or viability. These formulas and ratios are sometimes complicated, but the essence of equity isn’t.
In its simplest form, equity is ownership, and whether we’re talking about home equity, owner’s equity, or equity interest, we’re essentially referring to how much that entity owns of the item being discussed.