Paid-in Capital vs. Earned Capital
The stockholder equity section of the balance sheet keeps track of how much money has been invested in the company by its owners. Owners can contribute capital to a company by either buying shares (paid-in capital) or reinvesting net income into the business (earned capital). Owners can withdraw equity through dividends or selling their ownership shares back to the company.
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Paid-in Capital
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When a person buys equity ownership in the company, it is recorded as paid-in capital. This is recorded in the same way for public and private companies. When a company decides to conduct an initial public offering, shares sold to the public are recorded as paid-in capital.
Earned Capital
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Earned capital is when earnings are reinvested into the company. It works the opposite way if a company records a loss in a time period. Earnings are recorded as an addition to earnings capital and stockholder equity. Losses are recorded as a subtraction from stockholder equity. It is safer to own a company with a positive balance for earned capital as it means it has made money since it was established.
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Impact
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The book value of stockholder equity is also the company's theoretical value if it is liquidated. Although it is not an exact method of calculating the liquidating value because some of the assets may be overstated or understated on the books, it does give some sense of a company's value.
Negative Stockholder Equity
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This is possible because paid-in capital is also part of the equation. If a company decides to leverage up and buy back a lot of shares or pay a big dividend, negative equity may be left. There also may be negative equity if the company continuously loses money. Also if the company has substantial assets that are either recorded at very low cost on the balance sheet or are not treated as assets by accounting standards, the company's equity may be understated. The company may then be able to issue non-recourse debt on those assets, debt only tied to the asset and not the company, and buyback shares in excess of asset value. Examples of that would be if a company purchased a farm 100 years ago, it would still be recorded at cost today even though it will be worth many times that.
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References
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