What does it mean to have equity in a company?

As an investor, it’s important to understand exactly what you’re buying when you commit capital to an opportunity. When it comes to startups, most opportunities allow investors to buy equity (or the ability to buy equity in the future). 

Here's a detailed view of what equity is, why it matters to investors, how it affects investor ownership, and how it is taxed.

What is equity?

In the private markets, equity in a company equates to an investor’s financial stake or total ownership in that company. 

When a VC or angel investor commits capital to a startup, they are typically buying equity–meaning that they are in a position to benefit financially from the potential future success of the business. 

When a company is first founded, 100% of the equity (or ownership) typically belongs to the founding team. 

However, as they grow and raise new rounds of funding, that equity gets split up between more and more shareholders. 

You can see a full breakdown of a company’s equity holders by looking at its capitalization table (or cap table), which we explain in detail here.

There are different types of equity an investor can have… and each type has different rules and benefits. Let’s dig into what those are.

Types of equity 

The two most common types of equity are common stock and preferred stock. However, there are also other types of equity that are equally as important to understand.

Here’s an overview of the types of equity you will see on a balance sheet, in the order in which they appear:

Common stock

Common stock represents ownership of equity in a company. Common stock is sometimes also referred to as common shares, ordinary shares, or voting shares—they are all synonymous. 

Here’s a simple example of how common stock is calculated:

A company with 10 million shares with $1 of par value would result in $10 million of common shares on the balance sheet (10M x $1 = $10M).

 Preferred stock

Preferred stock is a lot like common stock, with a few distinguishable differences. 

Unlike common stock, preferred shareholders often have no voting rights, but have priority over common shareholders when it comes to dividends or other payouts. 

They may also have special rights in case of a “down round” or any other event that reduces the valuation of the company. 

For example, if a startup fails and is liquidated, preferred stockholders may get more of their investment money back than common stockholders.

Treasury stock 

Treasury stock is the segment of a company's stock that has been repurchased by the company and is therefore no longer available for public trading. 

When a company buys back its own stock, it reduces the number of shares outstanding, which can expand the value of the remaining shares. 

Treasury stock can also be used to finance acquisitions or to buy back shares from employees who have exercised their stock options. 

While treasury stock does have some benefits, it can also tie up a company's cash and may limit its ability to raise money in the future. 

Contributed surplus

Contributed surplus is used whenever shares are sold at above their par value.

Two entries are made on the balance sheet when a contributed surplus occurs:

• 1st entry: shows how much money was raised by the sale of shares at par value

• 2nd entry: shows the amount raised above par value

In the example below, ABC Co. sells 20,000 shares at $50 per share for a total of $1,000,000. Each share’s par value is $10, meaning the contributed surplus for each share sold is $40:

Source

Additional Paid-in capital

This one’s easy… it’s simply another term for contributed surplus—same as above.

Other comprehensive income

Other comprehensive income (“OCI”) includes revenues, expenses, gains, and losses that have not been realized yet. They are excluded from net income on an income statement and represent the balance between net income and comprehensive income. 

Any unrealized gains or losses on unsold securities are an example of other comprehensive income. After the investments are sold, the realized gain or loss is transferred to the net income section of the income statement.

Here’s an example:

Assume you own a bond portfolio that isn't yet at the maturity stage (and hasn't been redeemed). 

In this case, the fluctuating value of the bonds (gains or losses) cannot be fully determined until the time of their sale (redemption). These fluctuations in value are considered comprehensive income. 

Retained earnings

Retained earnings represent net income that is not paid out as dividends to shareholders. Instead, it’s retained (held onto) for reinvesting in the business or to pay off future debts.

Retained earnings can be a useful tool to link income statements and balance sheets. They act as a merger between the two reports; recorded under shareholders’ equity. 

If a company doesn’t believe it can make a satisfactory return from its retained earnings, it will often distribute the proceeds to shareholders in the form of dividends or buy back shares.

Here’s an example of Amazon’s 2017 balance sheet taken from Corporate Finance Institute’s Amazon Case Study Course. 

Types of equity in early-stage companies

Companies that raise on Republic use a few different types of securities and agreements that can reward their investors with equity:

Crowd SAFE (Simple Agreement for Future Equity) 

A Crowd SAFE is an investment contract between investors and companies looking to raise capital. Individuals make investments for the potential chance to earn a return. Equity provides the ability to receive a return via potential dividends or a cash payout if the company is acquired, goes public, or sells all of its assets.

Convertible note

A convertible note is a hybrid security that starts out as unsecured debt, accruing interest on the principal invested up until its maturity date. 

If a startup undergoes a trigger event—like a subsequent equity raise at a higher valuation—the note will convert into equity. 

When this happens, the investor ceases to be a lender and becomes an equity shareholder. In other words, they go from being the “bank” to becoming a part owner of the company.

If the note does not convert by the maturity date, the investor may have the right to “call” the note and receive repayment of their principal plus accrued interest, or the note may convert upon maturity. 

Typical maturity dates range between 18 and 24 months from investment; maturity accelerates upon a qualifying financing or liquidity event.

Equity

Although less common, some companies do host raises on Republic that offer equity to investors right away. That means investors don’t have to wait for a trigger event or liquidity event to have an ownership stake in the business.

Investing in a company is just one way to acquire equity. In fact, many early-stage companies offer equity packages to their employees, advisors, and other important individuals. 

Why do companies offer equity to employees?

There are several reasons why companies offer equity to employees, including:

• To retain top talent 

• To align employee and company interests 

• To build employee loyalty

Most companies have a set vesting schedule and cliff for their equity compensation, which is the amount of time that an employee must work at the company before they are eligible to cash out their equity. 

However, some companies may allow employees to cash out their equity sooner if they meet certain conditions, such as leaving the company or being fired.

**It’s important to note that straight equity is relatively rare. 

In most cases, employees receive a mix of salary, bonuses, and stock options. The reason for this is that companies want to align the interests of employees with the long-term success of the company. 

By giving employees a stake in the company, companies hope to encourage them to make decisions that will benefit the company in the long run. 

While equity arrangements can be beneficial for both employees and employers, they also come with risks. 

If a company's stock price falls, employees may see their equity holdings diminish in value. 

For this reason, companies typically structure equity packages as part of a broader compensation package that includes salary and bonuses. This way, employees still have some stability even if the stock price fluctuates.

How can investors sell their equity and make money?

Exactly when and how an investor can sell their stake in a company depends on which type of agreement they invested under. 

For example, investors in a Crowd SAFE have to wait for a liquidity event—a merger, acquisition, IPO, direct listing, etc.—before their investment converts to equity.

Convertible note holders may see their investment convert to equity much earlier. 

For example, if the company raises another round of financing at a higher valuation (also a trigger event for the Crowd SAFE), as long as a company stays private, investors won’t be able to sell their shares until a liquidity event, or exit, takes place… 

Occasionally though, a startup’s founding team or lead investors may reach out to early equity holders and offer to buy out their shares. 

This can be a great way to get liquidity—but keep in mind that if VCs want to buy up more of the business, they most likely believe it still has significant growth potential.

Any time you do sell your stake in a business, there are important tax implications to be aware of.

How is equity taxed?

First, it’s important to note that you don’t have to pay taxes on equity until you sell it. 

A profit is only “realized” (and subsequently taxed) when it is sold. Equity that has accrued value but has not yet been realized is called an “unrealized” or “paper gain,” and thus not taxable. 

The rate at which gains are taxed depends on how long you have owned the stock. 

If you hold the equity for more than one year and it grows in value, it counts as a long-term gain, which is taxed at a lower rate than equity held for less than a year.

The long-term capital gains tax rate is currently 15 percent for the majority of taxpayers (see chart below). 

For those in the highest tax bracket, the rate is 20 percent, while those in the lowest pay zero tax.

Short-term gains are taxed on a much more granular level since they are taxed as ordinary income (see the chart below to find your rate). 

Short-term gains are added to your total income. If this puts you in a higher tax bracket, then you will pay a higher tax rate. This is why some people will not sell their stock during high-earning years.

If you sell your equity for a profit, you will owe taxes on the capital gains. You will need to report your sale on your tax return and pay the appropriate taxes. If you have losses in addition to your gains, you may be able to offset some of the taxes owed.

2022 short-term capital gains rates

Data sourced from IRS

2022 long-term capital gains tax brackets

Data sourced from IRS

If you want to learn more about how investments into private companies can impact your taxes, check out our handy guide here. 

Benjamin Graham, the father of value investing, said this about equity in his famous book, "The Intelligent Investor":

“A stock is not just a ticker symbol or an electronic blip; it is an ownership interest in an actual business, with an underlying value that does not depend on its share price.”

This philosophy can be applied not just to individual stocks, but also to entire businesses. 

When you're looking at a company, it's important to understand the different types of equity that make up its ownership structure. 

By understanding these concepts, you'll be better equipped to assess a company's worth and make informed investment decisions.

Ready to start your investment journey with Republic?

This educational article is provided by Republic to help its users understand how this topic in detail. It should not be construed as investment advice as it is impersonal, disinterested and was produced by Republic for Republic’s users, without remuneration received or expected.