In this article, Waypoint Private Capital explains what capital structure is and why it's important for privately held business owners and entrepreneurs.
What is Capital Structure?
Capital, which is just another word for money, is a necessary component of every business. It is needed to start a business and fund losses, growth, and asset purchases. The two primary capital sources available for funding a business are equity and debt. The capital structure of a company is simply the percentage of each type of equity and debt to the total capital of the business. Financial theory shows there is an optimal capital structure for each company that maximizes the value of the equity. However, at small- and medium-sized companies that are not run by finance professionals, capital structure is rarely discussed and is typically constructed by choice rather than theory.
That choice is usually driven by emotion, capital availability, and past experiences. It is important for business owners, investors, and lenders to understand the capital structure of a company and the implications that capital structure has on potential growth, investment return, and risk.
Basics to Start the Discussion
Equity and debt are the broad categories comprising capital structure, but within each of these categories are many options. The equity category is very simple with LLC’s and S corporations because they are limited to one class of stock, therefore the equity appears as one number on the balance sheet. However, with C corporations there can be multiple classes of common stock. Retained earnings are also considered to be a component of the equity in a business. Equity is considered permanent capital and does not have a required payout to shareholders. It is the most expensive source of money in the capital structure.
The debt component of the capital structure is usually more complex than the equity component. Companies often have short-term debt (due in one year or less) and long-term debt (due in more than one year). Short-term debt is the debt used to fund operations and is secured by accounts receivable and inventory. Long-term debt is typically used to fund purchases of equipment or real assets and is secured by those assets. It is also common for private companies to issue unsecured long-term debt to investors or lenders in the form of notes payable. Larger private companies may also be able to issue unsecured long-term bonds to help fund the operations of the company or asset purchases. Debt is considered temporary capital and requires a monthly payment of interest and principal to the lender. Senior debt is the least expensive source of money in the capital structure. Unsecured notes are the next cheapest source of capital.
Preferred stock, which is only found in C corporations, is a hybrid security that is a cross between equity and debt. It has no maturity date, so is considered equity and shows up in the equity section of the balance sheet. However, it also will have a stated dividend rate that requires periodic payments of dividends, a feature which is more like debt. Preferred stock terms vary widely and can range from simple to complex. Preferred stock is the second most expensive source of money in the capital structure.
Scenario Set Up
Using an example is the best way to demonstrate the impact that differing capital structure choices have on a company.
Imagine two companies that both have the same amount of total capital invested in their businesses, generate positive working capital, are profitable, have unlimited growth opportunities, and are exactly the same in every way except for their capital structure.
Impact on Growth
Considering the scenario laid out above, which company can support faster growth through its internally generated cash flow? Growth almost always consumes operating cash flow due to the buildup of accounts receivable and inventory, so we need to determine how the capital structure of the two companies impacts cash flow. The capital structure of EquiCo is all equity, which is permanent capital that does not have any current payment requirements and thus does not consume any of the cash flow produced by the operations of the company. DebCo, on the other hand, has a large debt component to the capital structure. This debt will certainly require monthly interest payments, and because it is temporary capital, will most likely also require monthly principal payments to pay the debt down over time. The interest and principal payments will both consume a portion of the cash flow created by the operations of the business. Therefore, EquiCo will have higher free cash flow and can support a higher growth rate than DebCo. This example shows that, all else equal, the higher the percentage of equity in a capital structure, the more growth the company can support through internally generated cash flow.
Impact on Investment Return
Based on the conclusion in the growth analysis above, it is pretty clear that more equity in a capital structure is better, right? Well, it is too soon to jump to that conclusion. If you are the investor, whether a professional investor, or an entrepreneur who put your life savings into the company, you are going to be concerned with the return earned on the invested capital. There are always investment alternatives to consider before choosing to make an investment, and one factor to consider when making the choice is the return you will get on your investment. Expanding on the initial scenario, let’s assume the total capital for both businesses is $5,000,000. EquiCo is 100% equity financed, so the investor/owner invested $5,000,000 into the company. DebCo is 30% equity financed and 70% debt financed, so the investor/owner only had to invest $1,500,000 into the business while borrowing the rest. If the company generates EBIT of $475,000 then EquiCo, which has no interest expense, will also have an EBT of $475,000 and the equity investor will realize a pre-tax return on investment of 9.5% (475,000/5,000,000). If DebCo’s pays 5% interest on their debt per year the company will have an interest expense of $175,000 and thus an EBT of only $300,000. However, because the investor in DebCo only invested $1,500,000 into the company, she will realize a pre-tax return on investment of 20.0% (300,000/1,500,000).
This increased return on capital is caused by the lower weighted average cost of capital of a levered company. Equity investors in private companies will often expect an annualized return on their capital of 20.0% or more, inclusive of dividends and capital gains. It is the most expensive source of capital. Debt on the other hand, is the cheapest source of capital, and is currently available for private companies for as low as 3.0% per year. EquiCo is 100% equity financed, so its weighted average cost of capital is 20.0%. DebCo is financed with 30% equity and 70% debt so its weighted average cost of capital is 9.5% ((.30 * 20%) + (.70 x 5.0%)). This lower weighted average cost of capital is what drives the increased return on equity. This example shows that, all else equal, the higher the percentage of debt in a capital structure, the higher the return on equity invested.
Impact on Risk
As seen above, using leverage (debt) in a business can dramatically increase the return on equity invested. Because of that dynamic, many investors and business owners push the leverage of the company too far. The flip side to the increased return on equity is increased risk. Increasing debt to a certain point, say 60% of total capital, has a de minimis impact on risk. However, beyond that point risk starts to increase steadily. A highly levered company might have a capital structure with only 10% equity and the remaining 90% debt. When leverage is that high, the risk of failure is dramatically increased because the interest payment and debt amortization usually consume a significant amount of the free cash flow generated by the company. If there is a major negative event in the economy, the company’s industry, or with one of their major customers, it could cause the company’s cash flow to decrease below the level at which it can service its debt. If that happens, the company could be forced into bankruptcy and the equity investors could lose their entire investment.
The recent bankruptcy of Hostess shows the risk that high leverage places on a business. Hostess emerged from its initial bankruptcy in February 2009 but was still highly leveraged. Even though they did not miss their revenue projections by much, other factors impacted earnings and the company was soon at a point where they could not meet their debt and pension liabilities. In January 2012 they entered Chapter 11 bankruptcy again, and after unsuccessful negotiations with the Bakers Union declared Chapter 7 bankruptcy in November 2012, leading to a liquidation of the company. It is likely the equity investors will lose 100% of their investment after the liquidation is complete.
Typically, when the CEO of a private company choses to use debt to capitalize the company, the banks will limit the debt they provide to 70% of the capital structure. Where we see companies get into trouble is when the company needs more capital and the majority owners do not want to raise additional equity because they do not want to dilute their ownership percentage in the company. If the bank does not support the capital needs, the CEO will then turn to private investors who will lend the company money through the use of subordinated notes. Even though these notes push the company’s capital structure into a highly levered and highly risky position, bankers will typically allow those notes because they are junior to the bank if the company is liquidated. The CEO and bankers are ignoring the impact this new debt will have on risk and cash flow. The debt might solve a short-term problem for the CEO and could work out very well if the capital is used to fund profitable growth. However, if these new notes are being used to fund past mistakes, or if there is a major negative economic event, cash flow at the company could fall to the level where the survival of the company is in jeopardy.
Optimal Capital Structure
The optimal capital structure theory suggests increasing the debt level in a company until it reaches a point where the benefits of the debt no longer outweigh the risks caused by excessive leverage. When trying to apply this theory to reality we find that optimal capital structure becomes as much art as science. The financial modeling is fairly complex and involves scenario analysis and the estimation of many variables. If you do not have the expertise to do this analysis a good place to start would be to analyze the differences in revenue, earnings, and operating cash flow for your company at its peak revenue levels in 2008 versus where they fell to in the trough of 2009 or 2010. Take 10% more off of the decrease in cash flow during that time and determine what level of debt your company could have supported during the trough. That debt level is a good place to start if you are aiming for the optimal capital structure that will lead to a good return on invested capital while not risking the company.
 Companies with negative working capital (i.e., they collect money from customers faster than they pay their vendors), which is rare, generate cash flow through growth rather than consuming it.
 Earnings before interest and taxes
 Earnings before taxes
About Waypoint Private Capital
Waypoint Private Capital is an investment banking firm that educates and advises middle-market, privately held companies through critical stages of their business' life cycle. Waypoint helps business owners and entrepreneurs sell companies, buy companies, raise equity and debt capital for growth and recapitalization, and plan for a successful exit from the business.
To learn more visit waypointprivatecapital.com or call us at 608.515.3354 or 918.633.2647 and speak with a Waypoint Private Capital expert.
Steve Sprindis is co-founder and managing director of Waypoint Private Capital. © 2013 Waypoint Private Capital, Inc. All Rights Reserved.