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Everything You Need to Know About Equity Investments

March 16, 2022
6
min

Equity investment is a way of diversifying and mitigating risk, and investors often alter the mix of investments. Find out some ways to invest in equity.

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The word “equity” is an investment term related to ownership that also has a number of other meanings depending on the context. Pay equity means compensating employees the same amount when they perform the same job. Home equity is the difference between what a homeowner owes on a mortgage and the value of the home. Equity, meanwhile, is a branch of law that developed with common law to correct for unfairness.

What are equity investments? 

In finance, equities are shares in the ownership of a company. This represents the amount of money that would be returned to shareholders if the company’s assets were liquidated, after the debt was paid. Although “securities” and “equities” are generally not used interchangeably, the terms “stock” and “equity” often are.

Investors buy equities, or shares in companies because they expect the company’s value—and the value of their shares—will rise. Investors profit if they can sell their shares for more than the cost, resulting in capital gains. The downside is the risk that investors lose money if the value of their shares declines.

Buying equities in publicly traded companies

Most investors buy equities in publicly traded companies listed on a stock exchange, such as the New York Stock Exchange. To buy shares, investors can place a purchase order on a web-based brokerage platform or even a trading app on a mobile phone. They also can purchase shares by placing an order with a traditional broker.

Buying publicly traded equities on an exchange has a number of advantages: the purchase is quick, costs are generally low and the price is publicly available to all investors. There’s one more advantage: Most shares traded on exchanges are highly liquid and can be sold as easily as they can be bought. 

Investing in private company or startup equity

Startups often compensate early employees and investors with the right to buy shares, or “equity,” in the company when they lack the cash flow to pay market-rate salaries. Those who have equity may then be able to sell their shares to other investors. Some investors buy stock of a private company that intends to go public as an investment strategy, anticipating a rise in value when it is listed on a stock exchange.

Investing in the equities of private companies differs in a number of ways from buying shares in public companies, but the main difference is that private company stock is not listed on an exchange. To sell, shareholders must find a buyer for their stock, and the company must approve the sale.

There are three ways for individual outside investors to buy equity in a startup:

  1. Crowdfunding sites. Individual investors can invest in startups via crowdfunding sites, although the SEC limits the amount individual investors can pour into one of these sites in a 12-month period.
  2. Purchasing shares. Investors can purchase shares in a startup at a fixed price by investing in a priced equity round. This price is made by agreement, and investors are generally accredited and invited by the company. There are exceptions to this rule: According to the SEC’s Regulation D Rule 506, a company can sell its securities to an unlimited number of accredited investors and up to 35 non-accredited investors, as long as they have sufficient knowledge to be considered capable of evaluating the risk. 
  3. Convertible securities. Investors can buy convertible securities, or an investment that eventually converts into equity. Convertible securities, like convertible notes, are often found in seed- and early-stage investments. Priced equity rounds are more common to later-stage startups. Regulation D allows several exemptions for non-accredited investors, although it is much easier for investors to buy notes when they meet the accreditation threshold.

Private equity and venture capital

“Private equity” also refers to the way a company is valued when it is not publicly traded. A company’s book value is calculated by subtracting liabilities from assets; the equity is this sum. Unlike shares of publicly traded stocks, private equity is not available to just any investor.

In general, only so-called accredited investors, meaning wealthy individuals or entities allowed to buy or invest in securities that are not registered with financial regulatory agencies, can invest in private-equity or venture-capital partnerships. The current threshold for an individual accredited investor is a net worth of more than $1 million; special employee certification; or for a business, a valuation of at least $5 million. Investors who don’t meet these criteria can invest in exchange-traded funds (ETFs) that invest in private companies.

Other uses of the word “equity”

Even within the financial realm, the word “equity” takes on different meanings. Here are some common uses:

  • Home equity. A homeowner’s equity is essentially the portion of their home that they own. It is calculated by subtracting the amount the owner owes on loans associated with the house from its appraised value. For instance, consider a homeowner who bought a house for $150,000 and still owes $50,000 on a mortgage. The market value of the home has risen to $250,000. The homeowner’s equity is the difference between what the house can be sold for and the amount still owed, or in this case, $200,000. Home equity can be useful in securing a home equity loan (also known as a second mortgage or a home equity line of credit).
  • Equity on a balance sheet in corporate finance. Equity is shown on a company’s balance sheet; it’s one of the most common metrics analysts and investors use to evaluate a company’s financial health. This number represents the shareholders’ stake in the company. It is calculated by subtracting total liabilities from total assets. Since equity is the number owed by the business to shareholders and owners, equity is considered a type of liability. Equity is used in financial ratios such as return on equity (ROE), a widely used measure of corporate profitability derived by dividing a company’s net income by shareholders’ equity.

What are equity funds? 

Equity funds are a kind of mutual fund that uses money from multiple investors to buy stock in a range of companies. Equity funds are the most popular of mutual funds and are promoted to investors who prefer to have a manager invest for them. Some hallmarks of equity funds are:

  • Limited exposure to individual company shares. Equity investments made through mutual funds spread assets across companies, which limits an investor’s exposure and helps diversify an investment portfolio. On one hand, this limits risk; on the other, it also limits dramatic gains.
  • Classified by market capitalization. Equity mutual funds can be categorized as large-cap, mid-cap, and small-cap, based on the market values of the companies in the fund. Often the companies in a fund are alike in some way; for instance, the fund might invest in companies listed on the S&P 500 or invest in companies in a certain sector, such as health care or technology.
  • Useful for those who prefer a hands-off approach. Equity mutual funds are selected by investors who have little time to manage their investments or would rather have someone do the job for them.

The bottom line

There are many ways to invest in equity: buying shares of public or private companies, investing in equity funds, or being compensated in equity as an employee. Equity investment is a way of diversifying and mitigating risk, and investors often alter the mix of investments, including their equity exposure, over time as they near retirement age.

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Certain information contained in here has been obtained from third-party sources. While taken from sources believed to be reliable, Titan has not independently verified such information and makes no representations about the accuracy of the information or its appropriateness for a given situation. In addition, this content may include third-party advertisements; Titan has not reviewed such advertisements and does not endorse any advertising content contained therein.

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