If you’ve ever owned stakes in a company, then you may already know what is meant by equity. However, equity accounting is not just about the shares owned by founders, investors, and shareholders. The concept of equity can be applied in a couple of different ways.
For today’s discussion, however, we will focus on the concept of equity that is linked with company ownership. We will dive into the major considerations when handling equity in your accounting.
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What is equity in accounting?
If your books are in order, your balance sheet should delineate your assets and liabilities. A company’s total equity can be measured either as the company’s book value or the company’s market value.
1. The book value of equity
A company’s book value is the difference between the total assets and total liabilities. The book value may be regarded as an owner’s equity but only when the company is owned as sole proprietorships or partnerships.
2.The market value of equity
The market value is the price a company would get if it were sold. For publicly listed companies, the market value is easily understood as the total number of shares multiplied by the share price.
For non-traded companies, it’s unclear what the market value of a company will be until it’s sold, especially in SaaS. The final market value at the time of selling will be determined by negotiation and auction-style principles.
3. Positive and negative equity
Positive equity refers to the financial situation where your business’s value is worth more than what it owes. It is the best situation to be in because it means that assets are more significant than liabilities. As you may have guessed, the reverse is the case for negative equity.
Whether your business has negative or positive equity is an essential factor to watch out for in your company’s accounting. Overall, knowing the book value of your equity can point out a company’s financial health regarding assets and liabilities, regardless of whether the company is privately owned or publicly traded.
The following two sections describe the market value and book values of equity in greater detail.
What is the market value of Equity?
The market value of equity, also known as market capitalization for publicly traded companies, is the total dollar value of a company’s equity according to the market. The market value of equity is a measure that investors can use to understand a company’s size. Market capitalization is calculated by multiplying the current stock price by the total number of shares owned.
You can think of the market value of equity as how much investors think a company is worth today. The market value of equity changes throughout the trading day based on investor sentiments.
The market value of equity for private companies is more challenging to calculate than public companies. Private companies do not make their financials available as public companies do.
Valuing a private company is often achieved by using a comparable company analysis (CCA) approach. According to this approach, to value an equity stake in a private company, an interested person looks for a similar, but publicly-traded company to compare specific financial growth metrics.
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Equity accounting vs. cost method
When a company purchases a stake in another company, the generally accepted accounting principles (GAAP) require that the investor use specific methods to account for its investment. The equity accounting method or the cost accounting method is usually employed.
The cost accounting method is used when the investor’s ownership stake in the investee is not substantial, usually less than a 20% stake. As such, the investor does not assert any influence or control over the investee. In utilizing the cost method, the stock purchased is recorded on a balance sheet as a non-current asset at the historical purchase price. The record isn’t changed unless the shares are sold, or additional shares purchased.
For instance, if a company, XYZ, buys a 15% stake in another company for $2 million, that’s precisely how these purchased shares will be valued on XYZ’s balance sheet, irrespective of the current share price. If a dividend of $15,000 is paid to XYZ at the end of a quarter, they’ll add this money to their company’s income.
Equity accounting methodology is used when the investor’s ownership stake in the investee is substantial, typically a minimum of 20 to 25 percent. The investor will exercise a high degree of influence over the investee’s business strategy and operating decisions with equity accounting.
Similar to the cost method, equity accounting records the investment as a cost. The investment is subsequently adjusted to account for the investor’s share of the company’s profit and loss. For instance, a company, ABC, acquires a 45% stake in another company, DEF, for $25 million. This $25 million investment in DEF earns ABC a seat on the board of directors. If, at the end of an accounting period, the DEF records $6 million income, ABC would get 45% of that income amount. This income would be accounted for as income.
Understanding Equity in SaaS
The standard definition of equity is the compensation that represents ownership. Simply put, equity in SaaS is the value of owning a SaaS company. This value is sometimes expressed as shares or sometimes expressed as just ownership.
Equity is commonly split among investors, founders, and sometimes the employees. The multiple stakeholders in a business split equity to ensure that some form of insurance is available if an unfortunate event should occur in the company. This insurance arrangement is especially common in startups. In SaaS, equity is the same as with traditional companies, but many people get into difficult situations when splitting the equity amongst coworkers.
Consider the following when splitting up the equity of your startup:
- Ideation - whose idea it was to start the business.
- Key investors - investors who provided a large part of the funding expect a fair split.
- Vesting shares and schedules - this is when some founders earn equity based on an agreement.
- Stages during the startup - individuals involved early on should receive high equity compensation for their sacrifice and efforts.
The meaning you derive from considering these points should help you develop a framework for fairness in splitting the equity. Other factors that would lend to clarity include:
- Ensure that the appropriate value is assigned to the equity.
- Create and store several copies of paperwork to serve as tangible evidence for every agreement reached.
- Create a valuation process to ensure that all effort made toward the business can be adequately compensated.
- Create a system that can return stock to individuals who decide to leave the business. This system must be fair and equitable.
Ultimately, strive for fairness during the split so that all professional relationships are maintained, and teammates have enough incentive to continue bringing their best to the company.
The different forms of Equity
Earlier, we pointed out more forms of equity beyond the first two types listed in this article. Equity as a concept goes beyond evaluating how much money a company is worth. Think of equity as ownership in any asset after removing all the debt associated with the asset.
If you think of it this way, different variations of equity exist, such as:
1. Brand equity
In determining the equity of some companies, especially big companies, the assets being evaluated may go beyond tangible assets, infrastructure, and machinery. The company’s reputation and brand identity are considered a form of equity in itself.
Take the Coca-Cola and Microsoft brands as an example. Throughout the growth phases of these large companies, their marketing and product or service delivery have gathered a considerable fan base, which gives the brand name some intrinsic value.
This is called brand equity, and this is the value of a brand relative to a generic alternative. Brands like Coca-Cola and Microsoft make up a significant part of their parent companies’ market value. Brand equity doesn’t refer to an actual monetary value, but it does contribute to the overall value of the company.
2. Property Equity
Equity in a property simply represents the value contained in the ownership of the property. A property owner can measure this by subtracting the mortgage debt owed from how much of the property they own outright.
Property equity comes from the payment made against a mortgage, including an increase in the property value.
Property equity is often used as proof of net worth, and property owners can use that equity to get a loan. For instance, suppose Company N owns an office with a mortgage on it. The office has a current market value of $175,000, and the mortgage owed totals $100,000. Company N has $75,000 worth of equity.
Equity can be described in terms like net asset value, book value, and shareholder’s equity. The meaning of a specific reference to the term equity would depend on the context. Still, equity (whether in book values or brand values) generally refers to the value retained in investments after all liabilities associated with the investment have been paid off.
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