Definition
In a company, equity represents the ownership interest attributable to its owners after liabilities are taken into account. In financial reporting, the IFRS Conceptual Framework defines equity as a distinct component of the entity's financial position, while IAS 32 defines an equity instrument as a contract evidencing a residual interest in an entity's assets after deducting its liabilities.
In startup investing, however, "equity" is commonly used more broadly to mean ownership in the company, usually represented by shares or another equity instrument.
When an investor provides capital in exchange for equity, the investor receives an ownership interest rather than becoming a lender to the company. The specific rights attached to that equity depend on the company's share classes, constitutional documents, investment agreements, and applicable law.
How does equity work?
A company can be thought of as being divided into ownership interests.
For example, suppose a company has 1,000 shares:
Founder A: 600 shares
Founder B: 300 shares
Investor: 100 shares
The investor owns:
100 ÷ 1,000 = 10%
The investor therefore holds a 10% equity stake in the company, assuming all shares have equivalent economic and voting rights.
Equity as a source of startup financing
When a startup raises equity financing, it issues or transfers an ownership interest in exchange for capital.
A simplified structure is:
Investor → Capital → Company
Company → Equity → Investor
Unlike debt financing, equity financing does not normally create a contractual obligation for the company to repay the invested capital simply because time has passed.
The investor instead participates in the company's potential future economic value according to the rights attached to the investment.
What rights can equity provide?
Equity does not necessarily give every holder identical rights.
Depending on the type of shares or equity instrument, holders may have rights relating to:
Voting
Dividends or distributions
Sale proceeds
Liquidation proceeds
Information
Participation in future financing
Conversion
Board or governance matters
Different classes of equity can have different rights.
This is why saying that someone "owns 10% of a company" may not provide the complete picture without understanding what type of equity they own and what rights attach to it.
Common vs. preferred equity
Two broad categories commonly encountered in startup financing are common equity and preferred equity.
Common equity
Common shares generally represent ordinary ownership interests and may carry voting and economic rights.
Founders and employees commonly hold common shares or interests.
Preferred equity
Preferred shares can provide contractual rights that differ from those attached to common shares.
Depending on the financing documents, preferred investors may receive rights relating to:
Liquidation preference
Dividends
Conversion
Voting
Anti-dilution protection
Information
Participation in future financing
These rights vary by transaction and jurisdiction.
Equity vs. debt
The fundamental distinction is the nature of the investor's claim.
Equity | Debt | |
|---|---|---|
Investor's position | Owner | Creditor |
Repayment | Not generally a fixed repayment obligation | Generally requires repayment under agreed terms |
Return | Depends on company performance and instrument rights | Usually based on contractual interest and repayment |
Ownership | Yes | No |
Risk | Generally higher | Generally senior to equity |
Upside | Can participate in company value growth | Usually limited to contractual return |
The precise legal and accounting treatment depends on the instrument.
IFRS distinguishes financial liabilities from equity partly by whether the issuer has an obligation to deliver cash or another financial asset.
Equity and dilution
When a company issues new shares to raise capital, existing shareholders can experience dilution.
For example, suppose founders collectively own 100% of a company before a financing.
The company issues new shares to an investor representing 20% of the company after the financing.
The founders' combined ownership becomes 80%.
The founders still own equity, but their percentage ownership has decreased.
Dilution does not necessarily mean that shareholders have lost economic value. If the capital raised increases the company's value sufficiently, a smaller percentage of a more valuable company can be worth more than a larger percentage of a less valuable company.
Equity and valuation
Equity ownership is closely connected to company valuation.
For example, if an investor invests $2 million for 20% of a company, a simplified post-money valuation is:
$2 million ÷ 20% = $10 million
The remaining 80% represents the ownership held by the existing shareholders under the simplified assumptions.
The actual ownership calculation can become more complicated when option pools, convertible instruments, different share classes, or other securities are involved.
Equity and the cap table
A capitalisation table, or cap table, records who owns what portion of a company and can include information about different securities and ownership interests.
For example:
Holder | Shares | Ownership |
|---|---|---|
Founder A | 600,000 | 60% |
Founder B | 250,000 | 25% |
Investor | 100,000 | 10% |
Employee pool | 50,000 | 5% |
Total | 1,000,000 | 100% |
The cap table can become more complex as the company raises additional financing and issues options, warrants, convertible instruments, or different classes of shares.
Equity and employees
Startups can use equity or equity-linked compensation to give employees an economic interest in the company's future value.
Common mechanisms include:
Stock options
Restricted shares
Restricted stock units
Other share-based compensation
The legal and tax treatment varies by jurisdiction.
Equity and company value
Equity holders generally participate in the residual economic value of the company after the company's obligations have been satisfied, subject to the rights attached to the relevant securities.
This means equity can have significant upside if the company grows substantially.
For example, if an investor owns 5% of a company and the company's equity value eventually reaches $100 million, the investor's 5% interest would correspond to $5 million before considering the specific rights, preferences, taxes, transaction costs, and other factors.
The reverse is also possible. Equity holders can lose some or all of their investment if the company fails.
Equity does not always mean ordinary shares
The word "equity" can refer to different forms of ownership interests depending on the legal structure.
For example, ownership may be represented through:
Ordinary shares
Preferred shares
Partnership interests
Other equity instruments
IFRS notes that categories of equity can differ depending on the nature of the organisation and applicable legal requirements.
This is particularly important when comparing companies across jurisdictions because legal structures and terminology can differ.
Example
A startup is valued at $8 million before a new financing round.
An investor invests $2 million in exchange for equity.
Under a simplified calculation:
Post-money valuation = $8M + $2M = $10M
Investor ownership = $2M ÷ $10M = 20%
The founders and existing shareholders collectively own the remaining 80%, subject to the actual financing structure and any other securities included in the ownership calculation.
Common misconception
Owning equity means owning a fixed percentage of the company forever.
No.
Ownership percentages can change when a company issues new shares, creates an employee option pool, converts securities, or completes subsequent financing.
An investor who owns 10% today could own a smaller percentage later if the company issues additional equity and the investor does not participate proportionally.
This is dilution.
