What all Business Owners Need to Know About Owner’s Equity
Big words with critical meaning, “owner’s equity” is the dollar value of the portion of the business you own. Sounds strange, right? You may be thinking that your company is worth a lot, especially in light of the amount of elbow grease you put into making it great, but is it? This article can’t answer that question for you. What we can do, however, is give you the tools to determine it for yourself and make data-driven decisions. A key point we hope to emphasize is that while equity is not the same as value, there is a relationship. We’ll attempt to explain the connection at the highest level, then dig down to refine the answer and better explain how equity and value are different but related.
Equity Does Not Equal Value
It seems simple when you think of your home: your equity is the portion you own; the rest is the portion that the bank owns (if you are still paying a mortgage). As an example, let’s say your home is worth $100,000 and you have a mortgage for $80,000. This means the “value” that you own outright is $20,000. Your home value is based primarily on the “fixed” assets of the home (# of rooms, type of appliances, options such as a pool or yard) as well as less tangible assets such as the neighborhood, proximity to schools, etc. As you pay down your mortgage, your equity increases. Likewise, as the value of your home increases, your equity increases. A similar approach is applied to valuing your business however it gets a bit murky as we introduce a concept of “Blue Sky” to roll up the perceived value of your business with relation to its position in the marketplace (is your business a known “best” of its kind? Do you have multiple patents or copyright-work?), the particular role you play in the business vs. other employees (are you the “known” entity? Do you have a specific employee or two that has created the majority of the ideas/work? What would you, or they, earn if you had to look for traditional work as an employee?).
Determining Your Owner’s Equity
To understand fully how much equity you have in your business, you first need to consider all the assets, liabilities and obligations, and cash flow your business has. Then, you add “blue sky” elements such as the age of owners, the role of owners/employees, the collective “know-how” of your team, your company’s market position, and some estimate of future value: if you did nothing different, what would all of these factors look like in a year? In five years?
Why is this important? All business owners should have a good idea of how much their business is “worth” for several reasons:
Owner’s equity, which appears on the Balance Sheet, provides lenders a good idea of the commitment the Owners have in growing the business. Should you want to make an improvement in your business, such as purchase new equipment or buy a new facility, it may be advantageous to get a loan rather than ask the owners to invest in these assets. While owner investment may increase their equity in the business (which does have some advantages), the cost of a loan can pose less risk to a mature business looking to expand as those expenses (interest paid on the loan) may be deductible in some cases thus reducing net income and potentially reducing income taxes.
Owners can benefit from greater equity specifically when they take distributions: if the distributions are less than their equity, those distributions might be tax-free! (Remember, in a small business - either LLC or S-Corp - the owners will pay taxes on the business profits, which are shown on the Profit & Loss statement; they don’t pay personal taxes on distributions IF the distributions are less than the equity an owner holds in the company).
Should the Owners decide to sell the business, while the value of the business must account for those Blue Sky elements mentioned above, Owner Equity on the Balance Sheet typically defines the lowest amount buyers are likely to offer for the business in addition to the value of any accounts receivable minus the value of accounts payable.
In our next segment in this series, we’ll discuss how to calculate Owner’s Equity and how Blue Sky applies. If you are further curious about the benefits of knowing what your Owner’s Equity is for your business, Archimedes C&C is happy to help you prepare your financial statements to determine just how much equity your business has. Just give us a call!