Equity is the measure of ownership in a firm or asset. The most common way shareholders can hold equity in companies is through stocks. Below is an introduction to equity and how they work.
Definition of Equity/shares
- There are two types of equity values: book value and market value. The book value of equity is defined as the difference between assets and the liabilities a firm holds. The market value of equity is defined by the price that investors think each share of the company is worth.
- Book value is the most commonly used definition of equity, especially for private companies. It is the value that accountants put on financial statements. The equation for equity is equity = assets — liabilities.
- The assets that a firm has include cash, inventory, fixed assets, goodwill, intangible assets, accounts receivable, intellectual property, property plant & equipment (PP&E), and prepaid expenses. Anything that a firm or entity owns and has value can be considered an asset.
- The liabilities that a firm can have include current and non-current long-term debt, short-term debt, lines of credit, capital leases, accounts payable, deference revenue, and fixed financial commitments.
How Equities Work
- Equities are usually decided between founders and first investors when a startup or new company is taking on funding. The founders and investors will decide what percentage they will each own and decide the shares outstanding that will be shared among early employees.
- Anyone in the public domain can have equity in a company by buying stocks. The more stocks a person has, the more of the corporation’s assets the person owns. Each unit of stock is called a share.
- An investor can get money back from their investment by selling the stock to get a profit or by getting dividends. Dividends are payments that companies make to investors.
- Many investors choose to go through a stockbroker to buy and sell stocks. There are the traditional stockbrokers that investors talk to over the phone or by other means, and online stockbrokers that investors interact with through the click of a mouse.
- For their services, stockbrokers will often charge fees, or trading commissions. Some stockbrokers, especially online stockbrokers, will charge fees for extra services such as trading stock options and using research databases.
- Equity can also be received directly from the company itself. Some companies offer a way to simply purchase stocks from their website, but this often comes with caveats. It is best for an investor to read the fine print and do a comparison with going through a traditional stockbroker.
- Usually, companies only let employees buy stock from them directly. Stocks are either sold to employees at a lower price, or they are given to employees as part of their compensation.
- Equity compensation occurs when a company gives an employee partial ownership in the company instead of or in addition to a salary.
- Equity compensation can be offered as stock options, restricted stock, or employee stock purchase plans. Each of these types gives companies control over how equities are paid out to their employees.
- Stock options, more specifically Incentive Stock Options, give the employee an opportunity to buy shares at a discounted price and with a tax break. There are other types of stock options, such as Non-qualified Stock Options (NSOs), which are taxed as ordinary income. Restricted Stock is offered in the form of company shares through a vesting plan that is paid out after achieving certain milestones for both employer and employee.
- With vested equity, payments are made in installments over a certain time, as per the contract.
- Restricted stock is the most common way that companies offer equity to employees. Stock options used to be the most common way, but due to past scandals and malpractice of companies like Enron, Restricted Stock is now the preferred way.
What Happens During an IPO?
- In an initial public offering (IPO), companies allow the larger public to own equity, which in turn gives the firm larger amounts of capital to work with.
- During this time, depending on how the equity was structured, the investor can cash out their stake in the company and earn a large payday. If the investor decides to keep their stake in the company, their net worth can exponentially increase depending on how well the IPO and the stock perform.
- During this time, the company is placed under intense scrutiny because the public is looking into their operations to determine whether to invest. Hence, a company will have to hire more lawyers and accountants to keep track of their finances, which may place an extra burden on their bottom-line, which may then affect the stock price.
- The price of a stock, or what an investor’s equity is worth, will depend on how the stock performs from the IPO.
Pros and Cons of Getting Paid with Equity
- If the company an employee works for performs well on the stock market, equity-based pay will always have good returns for the employee.
- It provides a way for employees to work at their favorite startup without bankrupting the company.
- Equity compensation provides an opportunity to get a huge payday if there is a buyout or IPO.
- There are tax benefits that come along with equity compensation.
- Many companies use equity as a way to pay their employees less than the market value. This doesn’t bode well for employees that work for bad-performing companies or companies that don’t eventually have an exit (IPO or buyout).
- Depending on the vesting plan that was agreed upon at the start of the job, being paid in equity might dissuade an employee from leaving a job, especially if it’s one they do not like.
- The employee shoulders most of the burden with taxes. Plus, valuations of private companies are very complex, so the IRS may demand more based on their own valuations.