Leverage, also known as gearing, can play a significant role in financing startups. It involves using debt as part of your startup\u2019s long-term capital structure. This article will explain leverage in more detail, the implications of using it for your startup, and its key stakeholders.<\/p>\n\n\n\n
Leverage refers to using debt as part of your startup\u2019s long-term funding. Leverage is commonly used in the context of engineering a startup\u2019s balance sheet to boost the value of shareholders\u2019 investments in the startup<\/a>.<\/p>\n\n\n\n Leveraging your startup\u2019s capital comes with an inherent increase in risk. Before distributing any available earnings to shareholders via dividends or capitalising returns by reinvesting them into the company, your startup must service its debt obligations. If your startup employs excessive leverage, it might struggle to repay its debt. The worst-case scenario is that your startup\u2019s debt obligations exceed its assets. In some cases, this will result in shareholders losing their entire investment.<\/p>\n\n\n\n Leverage describes using debt in your startup\u2019s capital structure. Your capital structure is the source of your startup\u2019s long-term capital. It is the funds that your startup uses to acquire assets that are used to generate earnings. These earnings should exceed the required rate of return that investors expect in investing with your company. <\/p>\n\n\n\n The way in which your startup blends the mixture of debt and equity is reflected in the capital structure. To illustrate this, we will look at two fictional startups:<\/p>\n\n\n\n EquCo Ltd is a startup that has raised all of its long-term capital through equity financing. <\/p>\n\n\n\n The founders injected \u00a3500,000 into the company in exchange for 500,000 x \u00a31 ordinary shares. The equity investors injected \u00a31m into the company in exchange for 500,000 additional ordinary shares. These ordinary shares are issued at a \u00a32, which is a \u00a31 premium.<\/p>\n\n\n\n EquCo Ltd has no long-term borrowings. At the point it raised additional financing, it had \u00a3500,000 of retained earnings, which is the product of EquCo Ltd\u2019s first two years of trading profits. <\/p>\n\n\n\n At the point EquCo Ltd allotted the additional shares, it had the following capital structure:<\/p>\n\n\n\n BlendCo Ltd also needs \u00a31m in financing. It decides to raise half through equity and half through borrowing under a loan note programme. It manages to secure \u00a3500,000 worth of debt financing by issuing loan notes to investors at 10% interest. All other aspects of its financing are the same as EquCo Ltd. <\/p>\n\n\n\n It has the following capital structure.<\/p>\n\n\n\n Both startups\u2019 capital structure is worth \u00a32m. <\/p>\n\n\n\n However, BlendCo Ltd has a leverage ratio of 25%, calculated as follows:<\/p>\n\n\n\n Long Term Debt\/Total Capital Structure = Leverage= 500\/2,000 = 0.25 x 100 = 25%<\/p>\n\n\n\n EquCo Ltd has no debt, so its portion of leverage is 0%. <\/p>\n\n\n\n\n\n Continue reading this article below the form\n <\/i>\n<\/a>\nUnderstanding Leverage and the Capital Structure<\/h2>\n\n\n\n
Case Study: EquCo Ltd <\/h3>\n\n\n\n
Source of Capital<\/strong><\/td> Amount (\u00a3000)<\/strong><\/td> Notes <\/strong><\/td><\/tr> Share Capital Account<\/strong><\/td> 1,000<\/td> 500,000 shares issued to founders + 500,000 additional shares issued to first-stage equity investors.<\/td><\/tr> Share Premium Account<\/strong><\/td> 500<\/td> UK law requires companies to maintain a share premium account. This accounts for any premium value a share is issued for.
In this case, it is \u00a3500,000, which reflects the fact that 500,000 ordinary shares issued at \u00a32 per share = \u00a3500,000 nominal value + \u00a3500,000 premium value. <\/td><\/tr>Retained Earnings<\/strong><\/td> 500<\/td> Retained earnings form part of your startup\u2019s equity. <\/td><\/tr> Total Equity <\/strong><\/td> 2,000<\/td> <\/td><\/tr> <\/td> <\/td><\/tr> Total Long-Term Debt<\/strong><\/td> 0<\/td><\/tr> <\/td> <\/td><\/tr> Total Capital Structure<\/strong><\/td> 2,000<\/td><\/tr><\/tbody><\/table><\/figure>\n\n\n\n Case Study: BlendCo Ltd <\/h3>\n\n\n\n
Source of Capital<\/strong><\/td> Amount (\u00a3000)<\/strong><\/td> Notes <\/strong><\/td><\/tr> Share Capital Account<\/strong><\/td> 750<\/td> 500,000 shares issued to founders + 250,000 additional shares issued to first-stage equity investors.<\/td><\/tr> Share Premium Account<\/strong><\/td> 250<\/td> This reflects that 250,000 shares were issued for \u00a32 each. The premium amount is credited here. <\/td><\/tr> Retained Earnings<\/strong><\/td> 500<\/td> Retained earnings form part of your startup\u2019s equity. <\/td><\/tr> Total Equity <\/strong><\/td> 1,500<\/td> <\/td><\/tr> <\/td> <\/td><\/tr> Bank Borrowings<\/strong><\/td> 500<\/td><\/tr> Total Long-Term Debt<\/strong><\/td> 500<\/td><\/tr> <\/td> <\/td><\/tr> Total Capital Structure<\/strong><\/td> 2,000<\/td><\/tr><\/tbody><\/table><\/figure>\n\n\n\n EquCo Ltd vs BlendCo Ltd<\/h3>\n\n\n\n