Determining the Proper Capital Structure for a Business
Written by Stefan Martinovic for Gaebler Ventures
What's the optimal capital structure for your business? If you haven't given that question any thought, this is a must read article.
Capital structure in business is defined as a firm's ratio of debt to equity in its financing activities.
This ratio defines the relationship between borrowed dollars versus dollars invested in the business.
The more money that business owners have invested in the firm, the easier it will be to attract financing, as it displays a great deal of confidence in the business and a lower risk to potential investors.
Abnormally high ratios of equity to debt are generally unsafe and lack fiscal stability in the long run. Conversely, abnormally high debt to equity ratios can also prove harmful if the firm is excessively leveraged.
Equity financing typically takes the form of personal stake in the firm by friends, relatives, customers, employees, and even other firms in the industry. Companies that are publicly traded issue equity in the form of different classes of stock.
In addition to individual stakes in the firm, equity can also be contributed to a business in the form of an investment by a venture capital group. These firms specialize in seeking out new business opportunities that are potentially lucrative but also bear with it a great degree of risk.
Many of the major technology firms today began as startups that were funded by venture capital and private equity groups. Once these firms went public, equity investors cashed in. However, for every startup that finds success and becomes publicly traded, there are many more that fail and leave investors disappointed.
An investment of equity by an individual or capital group entitles the investor to a certain degree of decision-making ability which is generally proportional to the investor's stake in the business. This embodies the caveat of excessive equity funding, as when more equity ownership is issued, there can be a difference of opinion between the business' management and stakeholders looking for the most return on their investment.
This is why it is important that a certain degree of debt financing exist in a business' capital structure.
Debt financing in business is generally derived from banks, savings and loan institutions, commercial finance companies, and the United States Small Business Administration (SBA). Banks generally act as a short term lender of demand loans, lines of credit, and limited purpose loans.
Generally, banks are hesitant to offer longer-term loans to small businesses, as the risk of default is higher. As a result the SBA acts to reduce financial risk and leveraging available funds in order to make long-term loans to small businesses possible. SBA loans are generally granted on a referral basis, although it is possible to contact the SBA directly.
It is important to examine the needs of the business and the timeline for reaching certain financial goals in order to determine the appropriate capital structure for a business. For instance, if a long-term loan is needed to construct a new facility and returns on the investment may not be realized for several years, equity funding might be a more viable option, as many equity investors who have confidence in the business are willing to issue longer-term debt in exchange for the possibility of a much higher return.
Conversely, if funding is needed to upgrade technology in order to increase productivity, short-term debt funding such as a line of credit might be a better choice. This timing and management of cash flows is critical to selecting the right type of funding and maintaining the long-term stability of the business.
Stefan Martinovic has an extensive body of work across the financial services, manufacturing, and retail industries. He is currently pursuing an MBA in Management and Entrepreneurship at The College of William & Mary.
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