Capital Structure: What Is it and Why it Matters

The capital structure of a company is potentially one of the most important choices a founders, owners and managers make regarding a business. At the same time, it is one of the subjects which founders and owners least understand. While capital structures can result in complicated scenarios, it is important for all businesses to have at least a basic understanding of what they are, how they work, and why they are so important. They can have profound effects to a business’s ability to obtain capital, grow, and potentially to survive.

What is a Capital Structure?

Simply put, a company’s capital structure is made up of all of a company’s debts and equity. The basic capital structure has four major components.[1] Those include (1) Senior Debt; (2) Subordinated or Mezzanine Debt (including Unsecured, Convertible, and other Hybrid Financing);[2] (3) Preferred Equity; and (4) Common Equity. The capital structure is typically expressed in terms of a stack showing the preference associated with each type of capital and organized in order of increasing or decreasing preference.

The diagram here is a typical capital stack with the highest risk (common equity) at the top of the triangle and the lowest risk layer (senior debt) at the bottom of the triangle. And with the higher risk — having to be behind all of those other layers — comes higher return.

Senior Debt

Senior debts are those that have priority over other instruments when it comes to repayment, such as a change in control of the company as in sales or recapitalizations, or in bankruptcy situations. They are also usually collateralized with the company’s assets or otherwise have priority or “first dibs” on those assets. These are considered fixed income assets as opposed to equity which is a variable return asset. When it comes to liquidation or sale, senior debts are paid ahead of mezzanine or subordinated debts, which are paid ahead of preferred equity and so on. In return, senior lenders typically receive lower returns in the form of interest rates and usually have fewer restrictive covenants or conditions.

Mezzanine Debt

These include debts that are either unsecured or are second in line to the senior lenders. This means that in a liquidation event, such as a sale, they have to wait in line until the senior debts are satisfied before they can receive repayment. This higher risk brings with it the ability to ask for higher returns in the form of interest. It can also come with increasing strings in the form of covenants. This category also includes hybrid debts. These are instruments such as convertible notes that can be converted into equity or vice versa. There are specific times within the lifetime of the note or bond where it can be converted. The rate or amount of the conversion is predetermined and it is virtually always left to the discretion of the holder of the debt.

Preferred Equity

While this is a form of equity, meaning ownership interest, preferred equity can and almost always does have the characteristics of both debt and equity. It has a fixed income characteristic in that it has fixed dividends, and at the same time has potential for future income as the valuation of the company increases. However, being equity, it still stands behind the claims of the debt holders, while being ahead of common stock. While it is entitled to dividends ahead of common stockholders, it typically does not have voting rights.

Like convertible debts, a company may also issue convertible equity. This usually is in the form of convertible preferred stock. This means that it is preferred equity that can be converted to common shares. The conversion rate is predetermined and similar to a convertible debt, the decision to convert is usually at the discretion of the owner of the shares.

Common Equity

This is a form of ownership, similar to preferred equity. However, it is at the very bottom of the capital stack, meaning that it stands behind all other forms of debt and equity. This represents ownership after all other obligations of the company have been paid. Therefore, it is the riskiest form of ownership, and as such, comes with the highest potential returns compared to the other layers of the capital structure.

Why Does Capital Structure Matter?

The capital structure of a company is a snapshot of all of the obligations of a company, whether in terms of debt, which is a fixed amount made up of loan principal and interest, or equity, which is a variable amount equaling to a percentage of the value of the company.

Beyond that, it is crucial to the company’s ability to obtain various types of financing. Depending on the ratio of debt to equity, and the obligations of the company relating to each, it determines the relative risk that a potential capital source is willing to take and how to distribute that within the company’s structure.

In fact, if not properly maintained, it can spell doom for obtaining any form of capital, be it debt or equity. For example, the amount of the debt burden of a company and the cost of servicing that debt (such as monthly payments) means that there is less money left over for funding the company’s day to day operations. This would mean that the company is a higher risk and as such, a potential lender would require higher interest in order to lend to the company.

If properly designed, a capital structure should serve the equity holders of the company. Instead of raising all of a business’s needs through equity, some of those is obtained through debts, creating a fixed annual cost. These are considered expenses to the entity. By maintaining a proper capital structure, a company can maximize shareholder value while minimizing the cost of its capital.

[1] It is not uncommon for the stack to be divided into five or more layers depending on the industry, debt structure of the company or even individual preference. For example, some separate out junior debt from mezzanine investors in situations where there are some unsecured or junior creditors that are senior to the convertible debentures. Similarly, some reduce the capital stack to three layers, rolling preferred and common equity into a single category as that better suits the particular situation they are addressing.

[2] This category also typically includes such hybrids as warrants and options.