“Capital structure” is a phrase that often comes up when professional investors, analysts, and pundits discuss the current state and future prospects of publicly traded companies. But every business, no matter how large or small, has a capital structure, and it’s important for business owners to understand this concept and what it means for them. Simply speaking, capital structure is about the ratio of different types of capital being used by a business. Debt and equity are the two most common sources of capital for most businesses, but a third type, hybrid securities, combines some aspects of the first two.
Debt financing involves a contractual agreement between a company and a third party that calls for payment of a predetermined claim (interest) regardless of the company’s operating performance. Interest payments are generally tax-deductible, and debt has a fixed life. Bank loans, commercial paper, and corporate bonds are examples of debt financing. Equity financing is permanent because it involves exchanging a share of ownership in the business in exchange for capital. Examples include owners’ equity, venture capital, and common equity (stock. It often provides for the payment of dividends, which generally are not tax-deductible. Hybrid securities share some characteristics of both debt and equity, with the most common type being a convertible bond, which can be converted to equity at a predetermined time and conversion rate.
The optimal capital structure (OCS) for any business is a mix of liabilities and equity that meets all its business objectives at the lowest cost to the business while adhering to all regulatory requirements and allowing for the adoption of relevant industry best practices and appropriate risk management. Formulating OCS can be a complicated undertaking for large, diversified organizations, but the basic steps involved in the process are the same for any business:
- Define the capital needed and the business objectives. This is necessary to determine whether there are any elements of the business plan that may dictate parts of the capital structure.
- Identify regulatory restrictions to make sure the capital structure you are planning will be in compliance with all applicable rules and regulations, both local laws affecting all commercial enterprises and industry-specific ones affecting the field in which you operate.
- Identify risk restrictions, including liquidity (your ability to meet maturing obligations as they come due), interest rate risk on debt that does not have a fixed rate, and exchange rate risk if you operate in more than one country or plan to.
- Identify the range, amount, and cost of funding instruments available. Many variables can affect the options available to you, including the legal structure of your company, the market(s) where you operate, and the regulations to which your business is subject.
- Build the optimal capital structure, that is, fill any capital need identified with the lowest-cost funding instruments available to you as determined in the previous step.
- Analyze the total financial cost of the OCS by estimating its weighted average cost of capital (WACC), which is the sum of each funding instrument’s after-tax cost multiplied by the percentage of the total capital structure it represents.
OCS for most growth-oriented companies will focus on internal over external financing, says Iqbal Ashraf, CEO of consulting firm Mentors Guild. “In general, avoid external funding, and if you have to raise external funding, get as much debt as you can service through at least one year of bad business.” Debt is easier to raise and cheaper than equity, and it leaves control of the business intact with the owners. The main risk of high debt is repayment when cash is tight, which can give you sleepless nights, lower the possibility of further financing, “and may even put your business at risk,” he says.
“Try equity after you are leveraged to your board’s comfort level or the industry average, whichever is higher, and get it from those who bring more to the table than just cash,” Ashraf adds. “Get ready for scrutiny, CPAs, and lawyers, and be prepared to share your profits in perpetuity.”
Optimizing capital structure can be a challenge even for those with a sophisticated financial background, but getting a grasp of the fundamentals is important for any business owner. A great resource that provides an easily understandable dissection of the concept and the process for achieving it is Optimizing Capital Structure Toolkit, a step-by-step guide with sample spreadsheets created by Women’s World Banking.
Disclaimer: Since the details of your situation are unique, you should always seek the services of a qualified CPA, tax advisor, and/or other financial professional.
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