You must have heard the term “capital structure” at least once in your life, especially if your family or friends have businesses. For people who are investment analysts, professional investors, or corporate officers, this concept is essential.
This article will tell you about capital structure, the types of capital, and why a sound capital structure is essential for startups.
All you need to know about Capital Structure
Capital structure is an essential part of a company. It helps the organisation run smoothly and lowers financial burden. Without a strong capital structure, the company is at risk down the road. Having an ideal capital structure is important for startups.
What is a capital structure?
Startups have to finance their operations in order to attain growth, which can be done by structuring the combination of debt and equity in a way that suits the business. This structure of finance is called the capital structure. They have to choose their approach from all the different available options. They can create equity through common or preferred stock, and/or debt (long & short-term) as loans and bonds. The route they choose will depend on the product they offer and the industry they are in.
There are trade-offs when the business uses debt or equity to finance the operations. Depending on the industry, the management will have to decide the amount to use and balance both to find a point of equilibrium suitable for their company.
Why is capital structure important for a startup?
Capital structure is an essential factor that contributes to the stability of the company. Startups need to have a good capital structure as this will determine if they will survive the initial stages. Other factors that also show this importance are:
- A startup with a good capital structure will draw investors
- The business will be efficient as all the funds and resources will be effectively used, preventing under or overcapitalization.
- As per the startup’s situation, the company will have the flexibility of changing its debt capital.
- Having a proper capital structure minimizes the overall cost of capital while maximizing the shareholder’s capital.
- In the form of higher returns to the shareholders, an effective capital structure will increase their profit.
- If your startup has a sound capital structure, the chances of share prices increasing are high, leading to an overall higher business valuation.
Factors determining capital structure
There are many factors that affect and influence the capital structure of a startup. This is why it’s necessary to focus on the important factors, including:
- Control – The shareholders type will determine the degree of control. If the startup has more equity shareholders than preference shareholders, they will have control and higher voting rights.
- Government Policies – It is important as a startup to stay informed on all the policies that the government has set, as it influences your capital structure choice. If there are significant changes in the fiscal and monetary policies, you may have to change your capital structure choice.
- Cost of Capital – Startups raise capital for its operations, and there are costs to do so. These costs that they incur is called the cost of capital. A company should generate enough revenue to negate this cost, and the growth can be sufficiently funded. One way of reducing the cost of capital is by balancing the debt and equity to get an optimal capital structure.
- Trading on Equity – To increase returns, startups borrow new funds using more equity as the source. When the rate of interest the startup pays on debt is less than the rate of return on the total capital or when the rate of interest is higher than the return, they choose to trade on equity.
Types of Capital Structure
The plan by which a business finances its assets by combining debt and equity optimally is called a capital structure. A business sources funds from various areas to finance its operations, some of them are retained earnings, equity shares, long-term loans, preference shares, and others. Startups have to make a crucial decision and choose the type of source they want to use to raise their capital. Choosing the right type of capital structure will show the strength of the business and also the cost of capital.
The types of capital structures have been explained below.
In exchange for common or preferred stock, equity capital is the funds received from investors. Equity is the core of the business, and you can further add debt to this for more funding. The moment an investor invests in this, their investment is at risk. The reason for this is that in a scenario where the firm is liquidated, the company will settle the creditors’ claims before the business pays the shareholders.
Irrespective of the risks, investors put their money into equity for many more reasons. Investing in equity shares gives the investor a degree of control in the business. Through this, they can make sure that the company is efficient, generating sufficient funds, and can pay dividends to the shareholders.
From a valuation perspective, equity capital is considered the total amount given back to the investor after all liabilities are settled in the case of a liquidated company. In the balance sheet, the par value of stocks sold, retained earnings, offsetting amount of the treasury stock, and the additional paid-in capital are components of the equity capital according to an accounting perspective. Equity capital is of two types:
#1 Contributed Capital
The total amount of money initially invested into the company by the owners and from shareholders as a cost for ownership is known as contributed capital. In other words, it is a part of the total equity recorded by the company. The contributed capital can be in the shareholders’ equity section as a separate account.
Contributed Capital can further be divided into two parts: the regular stock account and the additional paid-in capital account. Here the regular stock account records the par value of a share sold. In the additional paid-in account, all excess payments are recorded. These accounts are created to record the amounts for legal purposes and do not provide any extra information. This is because investors look at the company’s total equity rather than the single amount given in these accounts.
The common entry written down when an investor buys shares from a company is to debit the cash account and credit the contributed capital account. Other transactions also involve contributed capital, such as receiving liability for stock and stock for fixed assets.
#2 Retained Earnings
Retained earnings is a part of the profit earned that the business keeps separately, for use to grow the business. In other words, it is the profits less dividends and any distributions paid to shareholders. This amount is always adjusted when an entry affects the revenue or expenses in the company accounts. If a company has a considerable amount in the retained earnings account, it means that they are financially strong. The formula to calculate retained earnings (RE) is: retained earnings at the beginning + net profit/loss – Dividends.
Debt capital is the type of capital the company raises by taking loans. This loan is also known as growth capital and is paid back at a future date. Debt capital is different from share or equity capital. This is because the lender does not become part owner in the company; they are just creditors. Normally, the creditor is entitled to a fixed interest rate on the loan annually, known as the coupon rate. In some cases, the loan is repaid depending on the company’s monthly revenue; this scenario is similar to revenue-based financing.
Equity holders, unlike debt holders, have rights in the company. But debt ranks higher than equity when it comes to annual repayment. Similarly, if a company is liquidated, the debt is paid off in full before the shareholders get repaid.
Note: In a startups capital structure, these loans are often in the form of convertible notes, like SAFE notes or KISS notes. They have a principal amount, may contain interest terms, and can convert to equity later on.
What is the optimal capital structure for a startup?
The ideal balance between debt and equity that results in a low WACC (weighted average cost of capital) is known as the optimal capital structure. The definition does not reflect the same in practice as companies have their own aspect of what they think represents the optimal capital structure. The reason every company has a different perspective also comes down to the industry they are in.
For example, a company in the petroleum industry will not find it suitable to have a high debt ratio as they deal in products with high liquidity. The ideal ratio should be 1:1. Whereas for a business in the banking industry, it is ideal to have a high debt ratio as they borrow capital to lend it to customers. Even though creditors charge financial institutions high interests, banks charge customers high-interest rates to counter it and earn profits.
Capital structure vs Financial structure
Capital structure is the long-term funds that are sourced by the business. In the balance sheet, it comes under the non-current liabilities and shareholders’ funds. The capital structure includes long-term borrowings, equity capital, debentures, preference shares, retained earnings, and others.
The financial structure is the plan through which company assets are financed. Financial structure is a more extensive concept than capital structure. It represents the entire liabilities and equity side of the balance sheet.
|Capital structure is the long term source of funds raised by the company.
|The plan by which the short term and long term funds are financed is the financial structure.
|It includes debentures, long term borrowings, preference capital, equity capital, and others.
|Financial structure includes the equity, preference capital, account payable, long & short term borrowings, retained earnings, and others.
|It is shown under shareholder funds and non current liabilities.
|Financial structure includes the capital structure. It is the entire equity and liability side.
When you compare the capital structure vs financial structure, the main difference is that the financial structure includes the capital structure.
Interested to Optimize your Company’s Capital Structure?
Startups have a hard time dealing with the hurdles that come their way during the first couple of years. It is essential that they find their optimal point. Finding the ideal capital structure will depend on various factors such as the industry of the business and the owners’ willingness to give up control of the company. Setting a strong and optimal capital structure allows the company to secure healthy finances.
One tool that can help is Eqvista. It is an advanced equity management tool that helps owners and investors track all financial information about the company’s capital and financial structure. The Eqvista platform also has other features, like our financial modeling in our Waterfall and Round Modeling Analysis, to help you make better financial decisions. Contact us today for more information to get started!