Understanding Capital Structure of the Company
09 December 2020
The capital structure of the company presents the combination of company’s existing debt and equity capital raised in order to finance or run the business operations of the company. The capital structure varies whenever there is change in invested equity and/or debt of the company. The nature of Debt in the capital structure varies from plain vanilla bond to complex convertible debts. Equity capital can be categorized under common and preferred equity in a broader sense.
Raising debt is very common since the cost of Debt is lower than the cost of equity because the lender earns an assured interest and owns seniority from the equity holders of the company. Debt is more risky for the business as it adds financial risk in the company. Any failure with reference to the payment of interest or repayment of principal amount may lead to the liquidation of the company. Broadly, debt can be classified under two categories namely non-convertible debt and convertible debt. Convertible Debt or convertible notes are hybrid securities with both debt-like and equity-like features. It can be converted into equity shares at a subsequent point in time based on certain future events.
Early-stage and venture-backed companies are often capitalized with several classes of equity securities, each having unique economic and control rights and hence, generally referred as Preferred Equity. Preferred Shares are issued with the primary aim of generating funds. In general, in case of any exit event, preference shareholders have preferential rights for payment of dividend and the liquidation preference over common shareholders.
Characteristics of Preferred Equity–
The presence of several classes of equity presents an additional layer of complexity, particularly related to value allocation. There are three main characteristics which define and drive a preferred equity or share Valuation – nature of coupon/dividend, redemption terms and conversion terms.
- Coupon/Dividend: Coupon can be zero, cumulative or non-cumulative. Additionally, one might see instances involving moratorium in accrual/payment of coupon for a part of the preference share tenure.
- Redemption: Redemption is the settlement in cash, either at maturity or in an amortizing fashion over multiple redemption dates. Redemption may be defined in terms of a fixed redemption premium, but far more popular option is to define it by an effective IRR requirement, with redemption premium quantum getting adjusted for coupon payments already made prior to redemption.
- Conversion: Conversion indicates settlement in equity shares of the Issuer. Conversion may be defined in terms of a fixed or formula driven conversion ratio/ price.
Deciding the suitable capital structure is an important decision of the financial management because it is closely related to the value of the company. Optimum capital structure is defined as the capital structure or the combination of debt and equity that leads to the maximum value of the firm while at the same time minimizes its Cost of capital.
Following are the factors which influence the decision of capital structure:
- Cash Flow Position
- Cost of Equity
- Cost of Debt
- Degree of Control
- Return on Investment
- Tax Rate
- Government Policies etc.
Organizations that use more debt than equity to finance their assets and support operations have an aggressive capital structure and a high leverage ratio. Thus, capital structure is vital for a firm as it determines it’s overall stability and hence the management should be more cautious while selecting its capital structure.