Capital structures are one of the most important subjects for a business, and yet commonly do not receive their due attention from a business’s founders, owners, and managers. In fact, they are among the least understood matters in a business. Although capital structures can present complicated scenarios, it is crucial for founders and owners to develop at least a basic understanding of what they are, how they function, and why they are so important to a business. The capital structure of a company can dictate whether what type, and how much capital a business can obtain.
What is a capital structure?
A company’s capital structure is “the particular combination of debt and equity used by a company to finance its overall operations and growth.” (Investopedia). Simply put, it is the structure of all a company’s debts and equity. The basics of a capital structure include four major components, two of the debt-based, and two equity based:1 (1) Senior Debt; (2) Mezzanine or Subordinated Debt (including Unsecured, Convertible, and other Hybrid Financing);2 (3) Preferred Equity; and (4) Common Equity. The capital structure is almost always expressed in a stack demonstrating the level of preference associated with each type of capital. It is organized in terms of increasing or decreasing preference.
The diagram here is a common capital stack. It has the riskiest capital (common equity) at the top and the least risky capital (senior debt) at the bottom of the triangle. Some reverse the stack by placing the lowest risk on top and the highest at the bottom. This better shows the order in which the capital can make claims against the company’s assets. Secured debts being first and common stock is last. Of course, with the higher risk – having to be behind all of those other layers – comes a higher return.
Senior debts receive priority over other layers and instruments when it is time for repayment. One typical way this occurs is when there is a change in control of the company, such as in a sale or recapitalization, or in the case of a bankruptcy. Senior debts are also commonly collateralized in some fashion – with the company’s assets or even those of its owners. This allows them to have priority over other debts and claimants when it comes to those assets, meaning that these collateralized or secured debts have to first be satisfied from those assets before other claimants can have a right to make claims. These debts are considered fixed-income assets versus equity which is a variable return asset. In exchange for being first in line when it comes to repayment, senior lenders typically receive lower returns in the form of interest rates. They usually also have fewer restrictive covenants or conditions.
These are debts that are either unsecured or are second in line with the senior debts. This means that in a change of control, such as a sale or liquidation, they wait in line behind senior debts and can only be paid once those creditors are satisfied. In exchange for accepting higher risk, these creditors ask for higher returns in the form of interest. The increased risk also brings with it the ability to require more restrictive covenants.
Mezzanine debt also includes hybrid debts, such as convertible notes. These instruments can be converted into equity at specific times within their lifetime at a predetermined rate or amount. The discretion to convert the instrument is almost always left to the holder of the debt.
Even though this is a form of equity – an ownership interest – it typically has some characteristics of both debt and equity to it. It can have a fixed income component in that it has fixed dividends. At the same time, it has the potential for higher (not fixed) returns as the company grows and increases in value. With its potential for higher returns than the fixed income components, such as senior and mezzanine debts, it comes with greater risk – it has to wait in line behind the debtholders. However, it is entitled to dividends and returns ahead of common stock. Unlike common stock, it typically does not have voting rights.
Similar to convertible debts, a company may choose to issue convertible equity. This usually comes in the form of convertible preferred stock, meaning that it is preferred equity that can be converted to common shares. As in the case of convertible debts, the rate of conversion is predetermined and the decision to convert is usually at the discretion of the shares’ owner.
Like preferred equity, common equity is a form of ownership. It is last in the line with everyone on the capital stack behind all forms of debt and all other forms of equity. Common equity is ownership after all of a company’s other obligations, be they debt or equity, have been satisfied. By definition, it is the riskiest form of investment or ownership. Therefore, it is entitled to the highest potential return as opposed to the other components of the capital stack.
Why is capital structure important?
The capital structure of a business embodies all of the business’s obligations. Those include debts – typically fixed amounts including loan principal and interest – or equity (ownership), typically variable amounts equal to a percentage of the value of the business.
A company’s capital structure is critical to its ability to raise or obtain financing of virtually any type. The ratio of its debt to equity and the company’s related obligations dictate the relative risk that capital sources are willing to take. It also dictates how capital is distributed within the company’s capital stack.
Specifically, if the capital structure is not properly maintained, it can be completely detrimental to a company’s ability to obtain any form of capital, be it debt or equity. For example, the debt burden of a company and the cost of servicing that debt – such as monthly payments – a signal to capital sources that there are fewer funds with which to handle the company’s day-to-day operations. Therefore, the company is considered a higher risk, meaning that a lender would likely require higher interest and more restrictive covenants in order to lend to the company.
A properly designed and maintained capital structure serves the equity holders. It counsels for raising some of the needs of the business in the form of debt, creating fixed annual costs, rather than diluting ownership. Maintaining a proper capital structure allows a company to maximize shareholder value while minimizing the cost of its capital.
1 Depending on the size and complexity of the entity or the particular industry or even individual preference, the stack may be divided into five or more layers. For example, some entities may have multiple subordinate debts that have entirely different priorities making creating separate layers more appropriate. By the same token, a less complicated structure may warrant a stack that has only three layers.
2 This layer commonly also includes such hybrids as warrants and options.