What Does My Startup’s Capital Structure Consist Of?

If you own a startup, you may hear talk of capital structures. It is often unclear what this means. In short, your startup’s capital structure refers to how your business has raised financing to fund its long-term operations. This article will give examples of capital structure, their implications, and how you can determine your startup’s capital structure. 

What is a Capital Structure?

When forming a business, it almost always needs upfront cash to fund its operations and grow. Likewise, throughout the life of a business, to continue growing, it may need access to additional sums of money. 

Sources of Capital 

There are two primary ways that businesses raise permanent capital:

• debt; and 
• equity. 

Most startups are limited in the amount of debt financing they can raise. Usually, this is because startups have limited tangible assets of ample value. Accordingly, banks and other traditional lenders have limited assets to take security over. For these reasons, most startups raise the bulk of their capital through a series of equity financings. This is where the term “Series Financing” comes from. Provided a startup can demonstrate to investors that it is hitting its growth targets, it can raise a series of equity financing rounds. 

Advantages of Different Kinds of Capital Structures 

When comparing the capital structures of different businesses, the starting point is to look at a capital structure comprised entirely of equity financing. That is a structure with no long-term borrowings. We can distinguish this from short-term borrowings, including purchasing supplies on credit.

On the other hand, the opposite of this would be a business funded entirely by debt financing. Practically, this is very unlikely. However, it is helpful to appreciate how debt affects the capital structure. 

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Equity-Only Capital Structure 

The biggest benefit of an equity-heavy capital structure is that the risk of defaulting under the terms of your borrowing is less than that of a debt-heavy capital structure. Where your long-term borrowings are zero, your business has zero credit risk. This is because it does not have any obligations under a loan. For instance, your startup does not have:

• an obligation to make interest payments; or
• to abide by the obligations lenders impose under loan agreements to abide by covenants, such as not taking on additional borrowings or keeping sufficient cash on hand. 

This is important because defaulting on a loan obligation has serious consequences. In the worst-case scenario, you may lose your business and its assets. 

Debt-Only Capital Structure 

Suppose you find a lender that will supply your business with 100% of the upfront capital it needs. In exchange, the business would need to make steady interest payments of a pre-agreed amount. However, provided your business generates enough cash to make these interest payments, you (and any other shareholders) are entitled to 100% of the remaining earnings. 

Under this arrangement, you would have an infinite return on investment because you do not have any of your capital at stake. However, you have a claim on all the business profits above the interest obligations. 

In practice, this arrangement is improbable. After all, a lender is unlikely to agree to take all the risk by providing all the capital but only receive a fixed return on its investment (the interest payment).

However, this example illustrates the effect of gearing. Debt can increase the amount shareholders receive on their investments. Put another way, look at the returns on investment of these two different companies:

Case Study: Gearing 

ABC’s shareholders’ return on investment is double. XYZ’s shareholders’ return on investment is triple. In other words, despite less money available to XYZ’s shareholders, they had to invest less to obtain more. 

This is the advantage of gearing. Provided a business can maintain enough cash to service its interest, the lender effectively subsidises the business’s profits. Of course, there is the risk that the business cannot service its debt. In this case, shareholders receive nothing.

How to Determine Your Capital Structure 

Determining the balance of your startup’s capital structure is simple. Assessing your balance sheet, determine the following: 

• how much your long-term borrowings or non-current liabilities are; and
• how much the value of its share capital account is.

In the UK, the share capital account equals the ordinary share capital account plus the share premium account. 

You also need to look at the retained earnings and other capital reserve accounts on the equity portion of your balance sheet. If there are any losses, you subtract this amount from your share capital account. This is your equity figure. It represents the total value of all the shareholders’ claims over the business’s assets. 

You will notice this is equal to the net asset value figure. This reflects the fact that shareholders have a claim over all the business’s assets, less all liabilities. 

Capital structures can become more complex when you use hybrid financing, like convertible debt or preference shares.

Key Takeaways 

A capital structure refers to how a startup finances its operations. This describes how much debt versus equity your business uses. Debt-heavy capital structures maximise shareholder return but increase credit risk. Equity-heavy capital structures impose no obligations on management to abide by loan agreements. It also minimises credit risk. 

If you need help with your startup, our experienced startup lawyers can assist as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us today on 0808 196 8584 or visit our membership page.