Key Takeaways

  • Common equity represents ownership in a company through common stock, retained earnings, and paid-in capital.
  • Unlike preferred equity, common equity holders assume higher risk but benefit from voting rights and greater long-term upside.
  • Startups often use common equity to attract founders, employees, and early investors when cash is limited.
  • The return on common equity (ROCE) is a key metric investors use to measure profitability attributable to common shareholders.
  • Common equity influences company valuation, capital structure, and access to financing.

Common Equity: What Is It?

Common equity is the total amount of all investments in a company made by common equity investors, including the total value of all shares of common stock, plus retained earnings and additional paid-in capital. The measure of common equity does not include the value of preferred equity, that is, the value of preferred stock or any other related interest (limited liability units, or limited partnership interests) with preferred equity status.   

Issues regarding equity investment in a company can be complicated. Potential investors are strongly advised to seek out the advice of professional legal and financial counsel before committing to any equity investment.

Components of Common Equity

Common equity is made up of three main components:

  • Common Stock – Represents ownership units issued to shareholders, typically carrying voting rights.
  • Paid-in Capital – Funds raised by issuing shares above par value.
  • Retained Earnings – Profits reinvested into the company instead of being paid out as dividends.

Together, these components reflect a company’s net value available to common shareholders once debts and preferred equity obligations are satisfied.

Common Stock

Common stock is one of two classes of securities issued by a company in the form of equity shares. (The other class is preferred stock) Both classes represent a degree of investor ownership in the company, but they also differ in several important ways. Common stock provides its owners with what is often termed a “residual” claim to a company’s income and assets. That is, when the proceeds from company profits are distributed, both lenders and preferred stockholders are paid before any payments are made to common shareholders. Other important differences between common stock and preferred stock include:

  • Common shareholders have voting rights in the company. Preferred shareholders do not.
  • Common stockholders may or may not be entitled to dividend payments.  A lack of dividend payment on common stock may, however, be beneficial to common shareholders because set dividends can have a negative effect on total capital gains. Preferred stockholders are, in almost all cases, entitled to dividend payments, and dividend payments are always made to preferred shareholders before any are made to common shareholders.
  • Common stocks typically outperform preferred stocks and bonds over the long run.
  • In the event of a company’s failure, common stockholders have no claim to company assets until all debtors and preferred shareholders are paid.

Common Equity in Startups

In the startup context, common equity usually belongs to founders, early employees, and sometimes angel investors. Employees often receive stock options that convert into common shares upon exercise.

Because common equity is junior to all other claims, its value can fluctuate significantly. This high-risk, high-reward nature makes it appealing in fast-growing ventures where early shareholders could see exponential gains if the company scales successfully.

Convertible notes or SAFEs (Simple Agreements for Future Equity) may also convert into common equity in certain financing rounds, though they more often convert into preferred stock.

Paid-in Capital and Retained Earnings

Paid-in capital is the amount of funds raised through investors when stock is issued, including par value of the shares. It consists of the funds raised in equity, but does not include funds from ongoing operations. Common equity includes all paid-in capital not derived from preferred equity.

Retained earnings are those earnings that are held back by the company to be reinvested in the company or to pay off debt, rather than paid out as dividends. Retained earnings, along with non-preferred related paid-in capital and common stock total value, are what make up common equity.

How to Calculate Common Equity

Common equity can be calculated using a company’s balance sheet with the formula:

Common Equity = Total Assets – Total Liabilities – Preferred Equity

Alternatively, it can be expressed as:

Common Equity = Common Stock + Paid-in Capital + Retained Earnings – Treasury Stock

This calculation is essential in evaluating shareholder value and is often used in ratios like Return on Common Equity (ROCE) to measure profitability.

Why Is Common Equity Important?

Common equity is important for several reasons. Knowing the amount of a company’s return on common equity (ROCE), for example, provides potential common stock investors with a clear idea of the returns received by the common (voting) equity holders when preferred equity holders are not taken into account, information critical in deciding whether or not to invest in the company’s common stock. A simple formula for calculating ROCE is:

Net income (NI) - Preferred dividend value / Average common equity = ROCE

  • Common equity = Total equity - preferred equity
  • Average Common equity = Beginning common equity + Ending common equity / 2

Other ways in which common equity plays an important role in the life of a company include:

  • Common equity can be important to a startup by providing a way to compensate company founders and attract experienced professionals, in lieu of high salaries, when on-hand cash is limited.
  • Options for the purchase of common stock are often included in the compensation packages of company employees, thus providing those employees with an incentive to work hard for the company’s success. Common equity, in fact, provides an incentive to founders, employees and financiers alike to succeed because success will result in a higher value to common equity holdings.

Benefits and Risks of Common Equity

Benefits for Shareholders:

  • Voting Rights – Influence over company decisions.
  • Potential for High Returns – Greater upside than bonds or preferred stock if the company performs well.
  • Long-Term Growth – Value grows as the company reinvests earnings.

Risks for Shareholders:

  • Last in Line at Liquidation – Paid after creditors and preferred shareholders.
  • Dividend Uncertainty – Dividends are not guaranteed and depend on company performance.
  • Dilution Risk – Issuance of additional shares can reduce ownership percentage and value.

For businesses, a strong common equity base signals stability, increases investor confidence, and may reduce borrowing costs.

Frequently Asked Questions

1. What is the difference between common equity and preferred equity?

Common equity gives shareholders voting rights and greater profit participation, while preferred equity offers priority in dividends and liquidation but usually no voting rights.

2. Why is common equity considered riskier than debt or preferred stock?

Because common shareholders are paid last in liquidation, they assume higher risk but may benefit more if the company succeeds.

3. How does common equity affect company valuation?

A company with higher common equity is generally seen as financially stable, which can attract more investors and improve creditworthiness.

4. Can employees own common equity?

Yes. Many startups offer stock options that convert into common shares, aligning employee incentives with company growth.

5. What is tangible common equity?

Tangible common equity excludes intangible assets like goodwill, giving a more conservative view of a company’s financial health.

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