Before we get down on the different equity types, it is important to be clear about what equity really is.
Essentially, business equity refers to ownership in the company. Equity can either be the amount invested in the business, or the total value of the business.
Equity is measured in terms of assets and liabilities, using the following formula:
Equity = Assets-liabilities.
You can further break down equity in to owner’s equity and stockholder’s equity, each of which are explained below:
This refers to the ownership of the business, and can be calculated by subtracting the business’ assets from its liabilities. In other words, the amount of owner’s equity is the amount of capital that you have in the business.
Owner’s equity is commonly found in partnership and sole proprietorship businesses.
Stockholder’s equity (also referred to as shareholder’s equity) is the amount of assets that the shareholders receive, once the liabilities have been deducted.
Stockholder’s equity is most common in businesses with a corporate structure.
Now that you have a fundamental understanding of what equity is and how it can be calculated, we can get down to talking about the types of equity as explained by Tommy Shek.
Types of Equity Accounts Explained:
An Explanation of Common Stock:
Common stock (also referred to as common shares) is a type of equity that represents the initial investment made in a company. This kind of equity gives the equity holders rights to certain business assets.
Generally, common equity is recorded at its par value (also referred to as face value). Therefore, the total value of the common stock can be calculated by multiplying the par value with the number of issued shares.
Tommy Shek says that common shareholders have a say in how the business is run, alongside having the following responsibilities:
- Board elections
- Officer appointments
- Determining business policies
- Corporate governance
In many ways, preferred stock is similar to common stock. The key difference is that owners of preferred shares receive their periodic dividends before the common stockholders – in other words, these shareholders are ‘preferred’ over their common stock counterparts.
For instance, let us assume that company A’s annual earnings are $500,000. The preferred dividend payable is $400,000 and the common dividend payable is $300,000. The preferred stockholders will get their full amount of the dividend, while the common shareholders will only receive the remaining $100,000 ($500,000-$400,000).
However, Tommy Shek explains that preferred stockholders do not get much of a say in how the company is run, and generally do not have the responsibilities and voting rights associated with common shareholders.
Preferred stock is generally purchased by short-term investors who do not wish to hold the common shares long enough to ride out any dips in the stock price.
To sum up, if you are considering setting up a corporation, or looking to change the structure of your sole proprietorship or partnership, it is important to understand the two main types of business equity and how they are different (and similar) to each other. We hope that this article by Tommy Shek proved helpful in that regard.