What Is Equity Capital?

Part I: The Fundamental Mechanics

1.1 The Accounting Definition

The equity of a corporation can be measured by the corporation's total assets less its total liabilities as reflected in the equation: Assets-(Liabilities)=Equity. If all of a company's assets were cashed in today and then all of its liabilities were paid, the amount left would belong to the shareholders. This is commonly called Residual Interest.

Equity = Assets - Liabilities

Equity is typically expressed as either Net Assets or Book Capital, and it acts as a buffer for creditors; if the value of the corporation's assets declines, then the Equity will be reduced before any of the Debt comes lose to it.

1.2 The Balance Sheet Components

Composition of Shareholders' Equity on a Balance Sheet Shareholders' Equity on the Balance Sheet is not represented as a singular dollar amount, but rather there are several types of equity accounts making up the Shareholders' Equity value on the Balance Sheet as follows:

• Share Capital (Common Stock) or stated value; The total dollar amount of all the shares issued by the company.

• Additional Capital (Common Stock) or paid (the excess money paid by investors for the amount of money they put into the company to obtain common stock (IPO) or to purchase newly-created shares through an advance purchase).

• Retained Earnings (the net income of the corporation continuously reinvested back into the corporation) represents the greatest source of Equity for a mature corporation.

• Treasury Stock represents the stock that the corporation has repurchased on the open market; it is a negative balance to Equity.

• Other Comprehensive Income is composed of the unrealized (paper) gains/losses the corporation may have stemming from forex translations (for example)/(until they have sold).

Part II: Types of Equity Capital

All equity shares are not created equal. Different classes of stock are often issued to allow companies to determine how to divide control of the company and how dividends/profits will be paid out.

2.1 Common Equity

• This type of equity represents the ownership of the company. Typically, common equity has voting rights for shareholders, usually one vote per share, and a right to dividends if they are declared by the company.

• Common Equity is the highest risk of all types of equity. If a company goes bankrupt, it will pay its common equity holders the last.

• Common equity holders may reap unlimited upside potential through capital appreciation.

2.2 Preferred Equity

• Preferred shares, or preferred stock, represent a hybrid security between debt and common equity.

• Preferred shareholders are paid dividends before common equity shareholders are paid. Preferred equity carries a fixed dividend rate.

• Preferred equity will usually carry a fixed rate of interest that is paid at regular intervals (e.g., when the preferred share is issued, it will carry the same interest rate as the ordinary bonds).

• Preferred equity holders do not have the same voting rights as common equity holders.

• Preferred equity holders generally will not have any voting rights with respect to the corporation.

• Preferred equity may be cumulative or non-cumulative! A cumulative preferred equity holder must be paid the amount due to them for any unpaid preferred dividends in the future before any preferred equity holder would receive any dividends out of retained earnings!

2.3 Private Equity vs. Public Equity

In the world of finance, equity can be divided into two main categories:

Private Equity and Public Equity.

• Public Equity is comprised of shares that are traded on various international stock exchanges (e.g. NYSE, NASDAQ, BSE). These companies have the highest level of liquidity and their value is determined by the open market in real-time.

• Private Equity represents ownership in a company that is not listed on a public exchange and is typically acquired from High Net Worth Individuals (HNWI) or Private Equity (PE) Firms. While typically more illiquid than public equities, PE investments can have a longer investment horizon.

Part III: The Lifecycle of Equity Financing

Financing Life Cycle of Equity Financing is about how companies raise capital. Most companies do not raise all of their equity at one time, but rather do so in stages or phases as they mitigate risk.

3.1 The Early Stage: Bootstrapping and Angels

The Early Stage of Angel Investment and Bootstrapping is where the company's founder(s) will initially boot strap the business and/or seek an individual Angel Investor to provide start-up equity. Bootstrapping is when a company's founders utilize their personal savings to fund their business in order to maintain 100% ownership of their business. To provide additional capital, the founder(s) may seek to find a wealthy individual (Angel Investor) willing to provide seed capital in exchange for a percentage of the company's equity. During this process, the company is said to have undergone its first "dilution" event.

3.2 Venture Capital (Series A, B, C)

Venture Capital (Series A, B, C) is required by companies as they continue to grow substantially and require significant amounts of capital from outside sources to fuel rapid growth. The Series A funding is focused on establishing a viable Product/Market fit. The Series B funding focuses on business development and scaling the business. The Series C funding and beyond will focus on establishing market dominance or acquiring another company. It should be noted that during these funding rounds, investors will often demand Preferred Stock with "Liquidation Preferences."

Part IV: The Cost of Equity

Equity investments are often thought of as "free money" due to the optional nature of dividends; however, equity is, in fact, the most costly form of capital because equity investors face the greatest amount of risk. Hence, equity investors expect to receive a much higher return on their investment than debt investors in exchange for taking on greater risk than debt investors.

4.1 Calculating Cost of Equity (CAPM)

The most common method to estimate the cost of equity is the Capital Asset Pricing Model (CAPM):

Ke = Rf + beta(Rm - Rf)

Where:

• Ke: Cost of Equity (The return shareholders expect).

• Rf: Risk-Free Rate (usually the yield on 10-year Government Bonds).

• Rm: Expected Return of the Market (e.g., S&P 500 or Nifty 50 historical returns).

• beta (Beta): A measure of volatility.

o If beta > 1: The stock is more volatile than the market (High Risk/High Reward).

o If beta < 1: The stock is more stable than the market (Defensive).

4.2 The Weighted Average Cost of Capital (WACC)

To determine the optimal capital structure and therefore minimize a company's overall WACC companies will attempt to locate the best balance between the use of debt and capital equity. Although tax-deductible interest rates give rise to cheaper interest rates, excessive use of debt increases the risk of bankruptcy, which increases the equity risk premium (higher cost of equity).

Part V: Key Equity Metrics for Analysis

In order to assess the performance of a company’s equity management, analysts use certain ratios to form a basis.

5.1 Return on Equity (ROE)

- ROE is regarded as the highest standard for efficiency. It reflects the number of profit dollars generated by a company for each dollar of shareholder equity invested in the company.

ROE = (Net Income)/(Shareholders' Equity)

- A company that has an ROE above 15% is viewed as efficiently managed and has a significant competitive advantage (or economic moat).

5.2 Book Value Per Share (BVPS)

Formula for BVPS:

BVPS = (Total Equity - Preferred Equity )/(Total Outstanding Shares)

The BVPS represents the approximate value of an individual share of the company if the company were to liquidate. If a stock trades below its BVPS, it is typically viewed as a "deep value" option (or a value trap).

5.3 Market vs. Book Value

- Book Value: The historical cost of the equity as reported in the company’s accounting statements (historical view).

- Market Value (Market Capitalization): The current price of the stock multiplied by the total number of outstanding shares (future-oriented).

- Price/BV Ratio: This ratio allows for the comparison of market value and book value. Tech companies typically have very high P/B ratios because the majority of their assets are intangible (IP, branding, software) and therefore not reflected as tangible assets on the company’s balance sheet.

Part VI: Corporate Actions Affecting Equity

Equity changes on a daily basis because companies take advantage of many different ways to manipulate their capital structure.

6.1 Share Buybacks (Stock Repurchases)

When management believes that its stock is trading at a discount, the company will purchase its own shares using excess cash.

• Reduces the number of shares that are available for sale, resulting in increased EPS (earnings per share) and also typically increasing the Market Price of the Share. This is a method of returning capital to the shareholder that is more efficient than distributing a dividend in many jurisdictions.

6.2 Dilution

The Dilution Effect is detrimental to existing Shareholders. When a company offers new shares to raise funds (Secondary Offering) or it gives employees excessive Stock Options (ESOPs), the original owners’ pie is divided among many more new owners.

• Your percentage of ownership decreases.

• The Earnings per Share is calculated based on the entire corporation’s net income divided by the total number of shares outstanding. Because the number of shares has increased, the calculated EPS is decreased.

6.3 Stock Splits

Stock Splits can be forward (e.g., 2-for-1 Split) or reverse (e.g., 1-for-10 Split) and will double the total number of Shares Outstanding but will half the Market Price of the Shares. The total value of the company’s equity remains unchanged. The purpose of Stock Splits is to allow retail investors to buy stock easier due to lower Price Shares than they would have at the new Market Price.

Part VII: Strategic Advantages and Disadvantages

Advantages of Equity Capital

1. All or part of the principal does not need to be repaid; therefore, it does not put a strain on cash flow during periods of declining sales.

2. Dividends are not an imposition and are considered to be a preference payment made to equity holders by an appropriate party.

3. Equity investors, such as venture capitalists, generally have much experience, knowledge, and contacts within their industries. They can provide much added value to entrepreneurs when they come on board and can assist start-ups in achieving success.

4. There is no requirement to pledge specific assets as collateral to raise equity.

Disadvantages of Equity Capital

• Selling equity dilutes the voting power of the founder, as the founder is essentially selling their vote (i.e., control) to equity owners; therefore, the Board of Directors can dismiss a founder from their company if they feel that the founder is performing poorly in their role as CEO of the company.

• Under CAPM, the expected cost of equity is greater than the expected cost of debt over the long term.

• An equity investment entitles future profits to be distributed among a greater number of investors than the limited partnerships used to finance the establishment of a franchise or develop a new product.

• Public companies are subject to strict financial reporting standards and regulatory compliance (i.e., Sarbanes-Oxley, SEC regulations, etc.) which is considered to be a disadvantage for private companies.

Conclusion

Equity Capital is the foundation of capitalism by providing a way to share risk and fund innovation. It is an Entrepreneur's fuel to a dream; for an Investor, a path to wealth accumulation; and for the Accountant, residual proof of creating value. Understanding equity is more than reading a Balance Sheet; it is understanding the rights, risks and rewards of owning (and operating) a commercially viable enterprise. From the high-stakes game of Venture Capital to the steady stream of compounding Dividends from Blue Chip Stocks, equity will continue to be the most important vehicle for long-term economic growth.