Equity

Equity just means “ownership”. If I start a business, I own it, whatever “it” is! When a business is small,
there may be only one or a few owners. But it makes sense to describe how the business is owned in
terms of shares of equity, so that it is easier to add or subtract – or buy or sell – later.

So if you and I start a business, and we each have an equal share of the business, then we will create
shares of equity [also called stock]. And we will each have the same number. So we start the business
and each of us has one hundred shares of equity, for a total of two hundred shares.
YOU -> 100 shares 50% ownership

ME -> 100 shares 50% ownership

TOTAL -> 200 shares 100% total

What does this mean? Well, each of us has equal ownership and an equal claim on the business. So if
the business earns $1000 you and I would each get $500 if we chose to pay ourselves, or we can reinvest
in the business. It also means that anything the business owns – machinery, equipment, cars, products
belongs equally to the two of us.
Now we need to grow the business so we take on a new investor – let’s call her Pat, who provides the
business with $10,000. In return, we create fifty new shares of equity and give them to Pat. What does
the new ownership structure look like?
YOU -> 100 shares 100/250 = 40% ownership

ME -> 100 shares 100/250 = 40% ownership

PAT -> 50 shares 50/250 = 20% ownership

TOTAL -> 250 shares 100% total

You and I still own 100 shares each, but there are now a total of 250 shares, so our ownership
proportion declines to 40% each. And Pat now owns 20% of the business. So if the business earns and
pays out another $1000, we each get $400 and Pat would receive $200. But the business has an
additional $10,000 to be able to grow in the future.

Also, providing $10,000 to Pat in exchange for 20% ownership means that we have implied a value for
our business, as follows:

$10,000 / 20% = $50,000

New Equity / ownership percentage = IMPLIED VALUE

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What if you and I think the business is worth $60,000 and Pat thinks the business is worth $40,000? Pat
would negotiate and try to argue that she should receive a 25% ownership stake in the business
[10,000/40,000] and we would try to argue that she should receive a 17% ownership stake in the
business [10,000/60,000]. Ultimately we meet in the middle and settle on 20%.

So now what? As the business grows, you continue to take on additional owners, but things can become
more complicated. Remember that the shares of equity entitle the owners to receive a proportion of
the financial benefits from owning a piece of the business. But ALSO, the shares of equity entitle the
owners to receive a vote on important matters. So in our above example, say another company wanted
to buy our business. The three of us would need to now vote on whether we should accept their bid for
ownership. If you and Pat vote “yes” and I vote “no”, I lose because my ownership is only 40% and
yours and Pat’s combined is 60%.
Often times, as a business grows, you want to take on additional owners who are interested in the
financial benefits, but you may not want them to have the same voting rights. For example, at one point
Google had THREE share classes of equity. Class A shares of Google represented traditional ownership
as we’ve described above. If you own one share of Class A Google stock you received one vote. But
Class B shares of Google equity received ten votes each. And Class C shares of Google received no vote.
But they each received the same proportion of financial benefit. This permits the founders and
shareholders of Google to provide a way to allow others to benefit financially from ownership of Google,
without diluting the control of the company. So a sample ownership “map” would look like, for
example:

Financial Benefits of a $600 distribution to the owners:

Class A Share receives $200
Class B Share receives $200

Class C Share receives $200

Distribution of votes for each of the owners:

Class A receives: 1 vote

Class B receives: 10 votes

Class C receives: 0 votes

In this way, the financial benefits are equally distributed but control of the company is concentrated
unevenly towards the B Shares, which is generally reserved for the founders and early employees and
investors. This type of division is fairly common.
At some point, your business may become sufficiently large that your need for additional capital to grow
exceeds the number of potential closely held shareholders in your network of employees, suppliers,

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customers, and additional outside investors. Moreover, maybe the business has been around for years
and some of the current owners may want to “cash out”. It is generally tougher for privately held
companies to provide ways to do this.

Let’s say, for example, your ownership map in seven years looks like:

YOU 100 shares and 10% ownership

ME 100 shares and 10% ownership

PAT 50 shares and 5% ownership

15 other owners at 5% each: 75% ownership

TOTAL -> 100%

An external consultant says that your business is worth a total of $10,000,000 (ten million dollars).
Some of the owners would like to “cash out”, meaning reduce their ownership stake in the business in
exchange for cash. What would need to occur? Either the current owners would need to buy them out,
or a new investor would need to purchase their ownership stake. Another alternative would be to take
the business public, which means that you make the shares available on the open market for anyone to
purchase or sell. This would be a long process and involve a lot of rules and regulations, but it would
allow for faster buying and selling of ownership, permit owners to cash out when they want, and
potentially allow the business to raise additional capital much more quickly and efficiently.

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