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Which Capital Structure Is Right For Your Business

Photo by Roberto Hund

Capital structure is a crucial aspect of any business as it determines the financial health and stability of the company. It involves the mix of debt and equity used to finance the business's operations, investments, and growth. Choosing the right capital structure for your business can take time and effort, is a financial risk, and can impact your business's profitability and sustainability.

We'll discuss the different types of capital structures so you can decide which capital structure is right for your business. From there, you'll better understand how to optimize your company's capital structure to ensure long-term financial success. Now, let's get into it!

1. Equity Capital

Equity capital is the total amount of money that all the shareholders contribute to a business in exchange for stock or a share in the company. It's sometimes called "owners' equity" or "shareholders' equity." There are two types of shares: common and preferred stock.

Common stock represents ownership in a company, gives the shareholder a right to vote on important corporate decisions, and has a claim on the company's profits in the form of dividends.

Preferred stock is similar to common stock but typically has a higher claim on the company's assets and earnings, such as a fixed dividend that must be paid before common stock dividends. The company lays out all these terms, entitlements, and conditions in the shareholder agreement.

2. Debt Capital

Debt capital is the money a company or business borrows to fund its operations. As the name implies, debt equity means the funds borrowed must be paid back. There are several types of debt capital, including:

  • Bonds: Bonds are long-term debt instruments that companies, municipalities, and governments issue. They pay a fixed interest rate to investors and are typically repayable over several years.

  • Bank Loans: Bank loans are a common form of debt capital that banks or other financial institutions provide. Loans can be secured or unsecured, with repayment terms and conditions that vary depending on the borrower's creditworthiness.

  • Lines of Credit: A line of credit is a flexible form of debt capital that allows a company to borrow money up to a predetermined limit as needed. This type of financing is useful for companies that need to access capital quickly and efficiently but don't need to borrow the total amount at once.

  • Term Loans: Term loans are debt capital that banks or other financial institutions provide. They are typically repayable over a fixed time, with a set interest rate and regular payments.

  • Commercial Paper: Commercial paper is a type of short-term debt capital that large, well-established companies typically issue. It is a cost-effective form of financing for companies with strong credit ratings and high financial stability.

  • Secured Debentures: Secured debentures are debt capital backed by specific assets or a guarantee. They offer more security to investors but also carry higher interest rates and stricter repayment terms.

3. Hybrid Capital

Hybrid capital is a type of financing that combines debt and equity financing features. It's a unique form of capital structure that allows a company to raise funds by issuing securities that possess characteristics of both debt and equity instruments.

Hybrid capital is a popular option for companies looking for flexible financing, as it balances the advantages and disadvantages of debt and equity financing. Hybrid capital is also known as hybrid securities, and they typically offer investors fixed interest payments or dividends, similar to debt instruments.

However, they also provide the opportunity for investors to convert their securities into equity at a later date. This gives investors the potential for a higher return on their investment than they would receive from a typical debt instrument.

This form of capital has several advantages for companies, such as offering greater financial flexibility, diversification of financing sources, and reducing the risk of diluting existing shareholders' equity. Companies can also tailor the securities to meet their specific financing needs, such as matching the maturity of the securities to the company's expected cash flows.

However, hybrid capital also has some disadvantages, such as the complexity of the securities, the potential for dilution of existing shareholders' equity, and the higher cost of financing than traditional debt instruments.

In summary, hybrid capital is a type of financing that balances the advantages and disadvantages of debt and equity financing. It's a flexible form of capital structure that can help companies meet their financing needs while maintaining financial stability.

Hybrid capital can take various forms:

  • Convertible bonds: These are hybrid securities that combine features of both bonds and stocks. Convertible bonds are debt instruments that can be converted into a predetermined number of shares of the issuer's common stock at a specific price. Convertible bonds offer the potential for capital appreciation if the underlying stock price increases while providing a fixed income stream.

  • Preferred stock: This type of equity has priority over common stock in terms of dividend payments and distribution of assets in the event of liquidation. Preferred stock may also have characteristics of debt, such as a fixed dividend rate and maturity date.

  • Mezzanine financing: This is a hybrid form of financing that combines elements of debt and equity. Mezzanine financing may include subordinated debt, equity warrants, or other securities with debt and equity features.

  • Contingent convertibles (CoCos): These hybrid security types can convert into equity if the issuer's financial performance meets certain predefined conditions, such as a decline in the issuer's capital position. CoCos are designed to provide additional capital to issuers during financial stress.

  • Debt-equity swaps: These are arrangements where a company converts its debt into equity by exchanging debt securities for ownership. Debt-equity swaps can benefit the company and investors, including reducing debt levels and increasing the company's equity base.

How to Choose the Right Capital Structure for Your Business

There are several factors to consider when selecting the most suitable capital structure. It's important to note that these factors vary from business to business.

1. Type of Business or Investment

Every business has distinct features depending on which industry category it falls into. The capital structure must suit its needs to ensure continued growth and maximize returns. Capital-intensive businesses such as manufacturing may require more debt, while a service or labor-intensive firm may prefer equity.

Generally, small businesses have difficulties raising funds since they have low credibility for significant borrowing, which, when availed of, may come with a high-interest rate that is unhealthy for the capital structure. Large business enterprises such as manufacturers and producers have an advantage as they demand higher and more flexible capital structures.

2. Cost of Capital

The cost of capital is the expected return on investment that a company needs to cover the costs of projects or other business ventures. This is the cost that the business will incur in obtaining the funds that are needed. To choose the right capital structure, you must generate enough revenue to meet the cost of capital.

The cost of capital gives you the minimum returns from the business that can justify investing. Another way of looking at it is that it shows the cost of borrowing funds from lenders or creditors compared to the projected returns on a given investment. This will indicate the effectiveness of capital utilization, helping the firm determine the specific type of capital structure to adopt.

3. Tax Considerations

Taxation varies from business to business, and the category in which your business lies may help determine whether you will make losses or profits on borrowed funds. Identifying the tax bracket in which your business is positioned to assess if the tax rate is manageable to ensure it doesn't eat into all your profits is crucial. In some countries, the tax rate varies, and some firms may deal with more than one type of tax.

4. Debt to Equity Ratio

​​The debt-to-equity ratio is an essential factor to consider when choosing a capital structure. It helps measure the firm's or business's financial leverage and evaluates how much it can cover its debt. It indicates how the firm can finance its operations through debt rather than its own financial resources.

The debt-to-equity ratio is a calculation done by dividing the company's total liability by its total equity. If it's low, it shows the business is utilizing more resources than it's borrowing. On the other hand, if it's high, then the company is using more borrowed capital. It's important to note that some firms depend more on heavy borrowing to run their operations than others, which influences their specific capital structure.

5. Government Policies

Businesses cannot ignore the impact of government policies. Policies on tax, business licenses and operations, location, employees, and many more may affect the capital structure of any business. This will, however, vary from firm to firm, and the effect may be significant or insignificant. The company must be aware of the relevant policies affecting their type of business to take appropriate decision-making measures.

In conclusion, choosing the proper capital structure for your business is crucial for its long-term financial success. It requires careful consideration of the benefits and drawbacks of different financing options and an analysis of your company's unique needs and goals. By understanding the various capital structures available, such as debt, equity, and hybrid models, you can make an informed decision that aligns with your business objectives.

Remember that your capital structure will impact your business's ability to grow. Consider the level of financial risk you assume and the cost of financing, so choosing the right one for your specific needs is essential. With this knowledge, you'll be better equipped to optimize your company's capital structure and ensure its financial stability over the long term.

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