finance
Equity
What's left for owners after subtracting liabilities from assets. The owner's stake in the business.
Definition
Equity is the owner's residual claim on the business: Assets minus Liabilities. If you sold every asset and paid off every debt, equity is what would be left for owners. It's the bottom of the balance sheet equation. Equity grows from two sources: retained profits (net income left in the business) and capital contributions (owners putting cash in). It shrinks from losses and owner distributions. For most service businesses, equity is the long-term measure of wealth creation - far more meaningful than this year's profit.
What sits inside equity on a US balance sheet
Equity for US LLCs and corporations contains several distinct components. Paid-in capital: cash and assets owners contributed when the business started or during later capital raises. Retained earnings: accumulated net profit not distributed to owners, year after year. Treasury stock (corporations only): shares repurchased by the company from owners; reduces equity. Other comprehensive income: unrealized gains and losses on investments, foreign currency adjustments. For a typical US small business, retained earnings is the dominant equity component because it grows organically through profitable operations. Watching retained earnings grow year over year is the cleanest single measure of business wealth creation. Distributions reduce retained earnings; losses reduce retained earnings; profits add to retained earnings.
Equity for LLCs versus S-Corps versus C-Corps
Different US entity structures track equity differently. Single-member LLC (disregarded entity): equity tracked as one owner capital account; contributions, distributions, and profits flow through. Multi-member LLC or partnership: equity tracked as separate capital accounts per partner; allocations follow operating agreement. S-Corp: equity follows shareholder count and ownership percentages; distributions must be pro-rata across shareholders or risk losing S-Corp status. C-Corp: equity tracked as paid-in capital plus retained earnings; distributions called dividends and taxed twice (once at corp level, once at shareholder level). Entity choice affects how equity behaves over time, what distributions are allowed, and tax treatment. Most US small businesses with multiple owners use LLC or S-Corp structures specifically because equity flexibility matters.
Building equity through retained earnings
The most powerful wealth-building mechanism for US small business owners is retained earnings compounding. Distribute too aggressively and equity stays flat; growth depends on outside capital. Retain too much and tax-paying becomes painful for pass-through entities. The disciplined approach: distribute 50 to 70 percent of net profit in healthy years, retain 30 to 50 percent. Over 10 years, retained earnings compound into substantial business equity that produces option value: pay for growth, weather downturns, exit cleanly. US examples: many founder-led service businesses grow from 100K equity to 5M plus equity over 10 years through retained earnings alone, without taking outside capital or diluting ownership.
Equity dilution when raising capital
Outside investment in a US business creates equity dilution: existing owners' percentage ownership decreases as new shares are issued. Math: a founder with 100 percent ownership who raises 500K at a 4M post-money valuation gives up 12.5 percent equity (500K divided by 4M), retains 87.5 percent. Successive rounds compound dilution. Typical US trajectory: founder owns 100 percent at founding, 70 to 85 percent after seed round, 50 to 65 percent after Series A, 30 to 45 percent after Series B, 15 to 25 percent at IPO. Dilution is acceptable if capital accelerates growth more than dilution costs ownership. Many US small businesses raise capital they did not need, dilute equity unnecessarily, and end with less personal wealth than if they had bootstrapped. Calculate the trade-off carefully before any raise.
FAQ
What is the difference between equity and net worth?
For a business: equity on the balance sheet is the formal accounting measure (assets minus liabilities). Net worth as a colloquial term often means the same thing or refers to the owner's personal stake. For an owner personally, net worth includes business equity plus personal assets minus personal liabilities. Be specific about which you mean. US business owners often conflate them and overestimate wealth by counting business equity at face value without adjusting for liquidity (business equity is illiquid until sold).
How is equity different from cash in the business?
Cash is a current asset on the balance sheet. Equity is the residual claim of owners on all assets after liabilities. A US business with 200K cash and 50K liabilities has at least 150K of equity attributable to cash, plus equity attributable to other assets (equipment, AR, intangibles). Cash and equity move together but are not the same. Distributing cash to owners reduces cash but only reduces equity if it exceeds retained earnings.
Should I value my business equity at book value or market value?
For internal management, track book value (the accounting figure on the balance sheet). For personal wealth understanding or any exit conversation, estimate market value, typically using EBITDA or revenue multiples (US small business multiples typically 2 to 7x adjusted EBITDA). Market value usually significantly exceeds book value for healthy businesses because book value excludes goodwill, brand, customer relationships, and growth potential. A US service business with 200K book equity might have 1.5M market value at 4x EBITDA on 375K EBITDA. The gap is one of the largest sources of wealth surprise for founders preparing to sell.
Can equity be negative?
Yes, and it is a red flag. Negative equity (liabilities exceed assets) means accumulated losses have eroded all paid-in capital. US small businesses with negative equity face restricted credit access, potential covenant violations on existing loans, and difficulty attracting investors. The remedies: profitable operations to rebuild retained earnings, owner capital injections, debt forgiveness or restructuring, or eventual wind-down. Negative equity is survivable but requires deliberate recovery work.
How does owner draws affect equity?
Owner draws (for sole proprietors and LLCs) reduce the owner capital account, which reduces total equity. Mechanically: draws are not expenses on the P&L; they appear on the cash flow statement and reduce equity on the balance sheet. Distinguishing draws from salary matters. For S-Corp owners, reasonable salary is paid via W-2 payroll (P&L expense) and additional profit is distributed as shareholder distributions (reduces retained earnings). The structure affects both equity trajectory and payroll tax liability; consult a US CPA for optimal entity-level strategy.
In your business
- →Track equity growth year over year - it's the truest measure of wealth creation
- →Avoid distributing all profit - retained earnings fund growth without needing outside capital
- →When considering investment, calculate the implied equity stake before agreeing terms