Equity has become a very common word across business press over recent years. For the past few years I am not the only person to have watched various companies go from zero to hero in what feels like months. We hear of the heroic 20 something becoming a billionaire when the cash in their equity after a buy out or an IPO.
Billionaire? Seems important then, but what is it?
I only became aware of equity in my early 30’s (yep, I am way past m early 20’s), prior to that I didn’t really take too much notice. I certainly didn’t understand the valuation process of buying a business nor the impact such valuations, sale, IPO has on anyone with equity.
So, I think it’s an important subject to know about and I thought I’d share some learning’s.
Equity is defined as ‘The Value of Shares Issued by the Company’ as per the Oxford English Dictionary. This is important. Equity itself isn’t the actual shares, rather the value of those shares. So, stating ‘I have 0.5% equity’ is incorrect. In this case one might have 0.5% of shares but the equity is the value of those shares. In fact the real equity is the different in share value between purchase and sale.
You’ve probably gathered then that in order to have some equity two things must happen:
- You must have shares in a company and
- Those shares must increase in value from the time of issue /purchaseto the time of selling
Here is an example.
You join a company in it’s early stages, say you’re employ number 10. The founders give you 1% of the company shares (also known as stock options). The shares are free as the company has no value and the 1% is worth say £1 (so the company is worth £100).
Over the next 10 years the company grows, is profitable and the founders wish to sell. The profit that year (EBITDA) is £6 million. The company has a valuation of x9 giving the actual valuation of £54 million.
NB: At this stage if the company had ay debt it would be deducted from the valuation.
Upon sale you realize your 1% shares. 1% of £54,000,000 is £540,000.
So, you’re just earned half a million or so.
The reason why equity is so important is because it is tied to the multiple associated with the company valuation. If in the above you had 2% rather than 1% you’d have earned over £1 million.
Of course, and this is the most important point, equity is zero (£0) if the company isn’t worth anything. Therefore, in order to create equity one must create value, thats is, something of value to someone else. This is the real trick.
When one buys shares on the stock exchange the principal is the same. You’re buying part of a company and trusting the management of that company to create more value and thus increase the value of your shares. One would think then that investors take long term approaches……more of that in later posts.
There are lots of complexities regards the issuing of shares, the types of options, tax, how one can realize the value etc. I am no expert but I shall jot down my thoughts and experience in coming posts.