A company’s capital structure is critical in its success.
From a technical perspective, the capital structure is defined as the equity and debt that a business uses to finance its assets, day-to-day operations, and future growth.
What Is a Company's Capital Structure?
The capital structure reflects all of your firm’s equity and debt obligations. It shows each type of obligation as a slice of the stack. This stack is ranked by increasing risk, increasing cost, and decreasing priority in a liquidation event (e.g., bankruptcy).
Senior debt is the lowest cost and lowest-risk form of financing — holders of this form of financing have first dibs on a company’s assets in a liquidation event. Because of the minimal risk that accompanies this block of the capital structure, senior lenders loan money at lower rates (i.e., lower interest payments and less restrictive debt covenants) relative to more junior tiers. Examples of senior loans include bank loans and debt secured by collateral. More junior forms of debt include no collateral business loans and mezzanine financing,
First and foremost, the capital structure is effectively an overview of all the claims that different players have on the business. The debt owners hold these claims in the form of a lump sum of cash owed to them (i.e., the principal) and accompanying interest payments. The equity owners hold these claims in the form of access to a certain percentage of that firm’s future profit.
Secondly, the capital structure is heavily analyzed when determining how risky it
is to invest in a business, and therefore, how expensive the financing should be. Specifically, capital providers look at the proportional weighting of different types of financing used to fund that company’s operations.
For example, a higher percentage of debt in the capital structure means increased fixed obligations. More fixed obligations result in less operating buffer and greater risk. And greater risk means higher financing costs to compensate lenders for that risk (e.g., 14% interest rate vs. 11% interest rate).
Consequently, all else equal, getting additional funding for a business with a debt- heavy capital structure is more expensive than getting that same funding for a business with an equity-heavy capital structure.
Equity vs. Debt Investment
For business owners, the decision to finance a company via debt or equity can be a crucial choice for the direction and future of the company. Both options have their pros and cons, so it’s important to carefully weigh the benefits and downfalls of each and determine how it will impact your business and personal life before signing on the dotted line.
Equity investment is when a business raises money by selling interests in the company. Investors, who could be as close to you as friends or family or as removed as angel investors or venture capitalists, take a percentage of your company when they agree to fund the business.
With equity financing, the investor is on the hook for the majority of the risk. If your business fails, you do not have to pay the investor back the money that was invested in the company. No out-of-pocket payments mean that you will also have more cash on hand to invest in the business upfront. This can be a huge relief for start-ups or small businesses that are just starting to turn profits and gain market leverage.
However, the downside of equity financing is enough that many small business owners to shy away from this option. Understandably, investors in your company will share your profits and benefit from your successes. As the owner of the company, you will reap a smaller portion of the rewards for your hard work, a hard pill to swallow when the time comes to pay your investors.
In addition to giving up some of your future profits, you’re also giving up some of your control of the company when you bring on investors. Before making decisions that will affect your business, you’ll need to consult with your shareholders and keep them abreast of company actions.
Just like taking out a loan for a car or a mortgage for a home, taking on debt
for a business involves borrowing money to be repaid to a lender, plus interest. Businesses may be eligible for an SBA-backed loan, a private loan, a line of credit from a bank, or a personal loan from friends or family.
Unlike with equity financing, the lener in a debt financing arrangement has no control over your business. Once the loan is paid in full, your relationship with the lender is over. A lender is only entitled to the agreed-upon principal plus interest of the loan, not any future profits of the company.
Other advantages of debt are that interest paid on the debt is tax deductible, and that the regularity of loan payments makes them easy to forecast and plan for out of monthly cash flow in comparison to fluctuating investor payments.
The disadvantages of debt financing are likely well known to any business owner who also has personal debt. Loan payments must be paid back on time, or the consequences can be severe for your business. By taking on debt, you are taking the risk that your company will be able to comfortable and confidently pay back the loan. Many business owners find themselves in a situation where loan payments hamper their ability to grow or stretch their funds too thin.
Although you won’t need to give up control of your company with debt financing, you will need to pledge certain assets of the company as collateral. And, even if the company is registered as an LLC or another type of business entity, lenders may still require you to personally guarantee the loan with your personal financial assets.