Unlike debt, equity capital is permanently invested in the business. The business has no legal obligation for repayment of the amount invested or for payment of interest for the use of the funds.
The equity investor shares in the ownership of the business and is entitled to participate in any distribution of earnings through dividends, in the case of corporations or drawings in the case of partnerships. The extent of the equity investor's participation in the distribution of earnings of a corporation depends upon the number of shares held. In a partnership, the equity investor's participation will depend upon the ownership percentage specified in the partnership agreement. Their ownership interest also carries the right to participate in certain decisions affecting the business.
The personal liability of equity investors for debts of the business depends upon the legal form of the organization. Basically, the investor who acquires equity in a partnership could be personally liable for debts of the business if the business should fail. In a corporation, the liability of equity investors (shareholders) is limited to the amount of their investment. In other words, if a partnership should fail, creditors could have a claim against the personal assets of the individual partners. If a corporation should fail, the only claims of creditors would be against any remaining assets of the corporation, not against any personal assets of the shareholders.
The purchaser of an equity interest in a business expects to be compensated for the investment in the following ways:
- Income from earnings distribution of the business, either as dividends paid to corporate shareholders or as drawings in a partnership.
- Capital gain realized upon sale of the business.
- Capital gain realized from selling his or her interest to other partners.
Capital gain is the term used to describe any excess of the selling price of an investment over the initial purchase price. For example, if you purchased an equity interest in a business for $5,000 and later sold it for $8,000, you would realize a capital gain of $3,000.
Long-term capital gains are those realized on investments held for a period longer than six months. These gains are subject to federal income tax at a lower tax rate than on ordinary income. Therefore, income tax advantages are often a major reason for the investor's desire to acquire an equity interest.
The equity investor in a partnership is entitled to a share of all drawings paid out to partners at a percentage established when the interest was purchased (and defined in the partnership agreement). For example, assume an investor acquired a 20% interest in a partnership. The distribution of earnings to all partners in a given year is $20,000. The holder of the 20% interest would receive $4,000.
If a business is sold or liquidated, the equity investor shares in the distribution of the proceeds. As with an earnings distribution, the share of the proceeds in a corporation sale depends upon the number of shares held. In a partnership, each partner's share of the proceeds is based upon the percentages specified in the partnership agreement. If the proceeds received by the equity investor exceed the original purchase price, this excess is considered a capital gain and taxed accordingly at effective rates more favorable than those for ordinary income. If the business were liquidated, the assets would be sold and the proceeds would first be used to discharge any outstanding obligations to creditors. The balance of the proceeds, after these obligations had been fulfilled, would be distributed to the equity investors in accordance with their shareholdings or percentages of interest.
As a business prospers and grows, the value of an equity interest grows with it. Therefore, the equity investor may be able to sell his or her interest at a price higher than the initial acquisition cost. For example, an equity investor in a corporation may have purchased his or her interest at $10.00 per share. As the business grows, he or she is able to sell the shares at $15.00 per share, realizing a capital gain of $5.00 (15.00 - $10.00) on each share sold.
In many cases, the equity investor in a small business is primarily interested in capital gains. Aside from the tax advantages described earlier, the equity investor usually realizes that the earnings of the small business are better retained in the business than distributed as dividends or drawings. Retention of earnings permits the business to grow so that the value of the equity interest increases. The investor can realize a return on the investment through a capital gain derived from selling his or her shares or upon sale of the business.
When businesses are first organized, equity capital is usually secured from a combination of sources such as the original owners' personal savings and through solicitations from friends, relatives, or other persons known to have financial capability for such investments. As the need for equity capital becomes greater, say $50,000 to $200,000, it is customary to seek capital through the services of professional finders, who receive a fee for securing the capital needed. These professionals normally have access to wealthy individuals, capital management companies, estates, trusts, and others with sufficient capital to make such an investment.
As higher levels of capital need, shares are sold through public offerings. The public offering seeks to attract a large number of investors to purchase stock, in large or small amounts. A market is then created for the stock. Shares purchased by the public, as well as the shares held by the original owners and any subsequent equity investors, can also be sold at the going market price. These transactions do not have a direct effect on the business' capital position since it does not receive the proceeds from the sale. The equity investor can realize a capital gain by selling shares at prices higher than the original purchase price.
The equity investor assumes substantial risk. Unlike the secured creditor, the equity investor has no specific claim against any assets of the business. In liquidation, all claims of all creditors must be satisfied before any remaining assets become available for distribution to the owners. Even then, the equity investor's participation in the proceeds is restricted to a share that is proportionate to the number of shares held or the partnership interest. Since the risks of equity investment are so substantial, particularly in the case of small businesses, equity investors expect a considerably higher return than the lender.
A lender might be willing to loan money to a business at an interest rate of 10% or 12% since it has certain legal protection in the event of default or liquidation. The investor of equity capital in the same business might seek a far higher return, perhaps 20%, 50% or even more in order to compensate for the added risk of equity investment.
