Understanding the Capital Structure of Your Practice

When making investment and financial decisions in your small business you will need a clear picture of the capital structure of your company. Capital is generally referred to as the source of cash for investment in the company. There are two sources of capital, selling ownership and borrowing money either as loans or selling debt such as bonds. Deciding which source and the balance between the two sources is an important decision.

Factors to Consider When Determining Your Capital Structure

Equity. Equity refers to the ownership of the company. Equity can and often equals control. When you raise capital by offering equity, you are selling an ownership stake in your company in exchange for capital, typically cash. Depending upon how you’ve structured the offering, the investor will keep certain rights and powers. They might want a seat at the board, be involved in the decision making of the company, and have a return they expect to earn. Selling equity can come with many strings. Carefully consider not only the financial cost of selling a part of your business but the intangible costs such as giving up some control of your business. When you borrow money, a loan is determined by the terms of the contract and rarely yields any control or decision making to the party issuing the loan. It might cost more and will always need to be paid, but you don’t give up any equity when using debt as a source of capital. Finally, if you do sell equity, consider what happens if the investor wants to sell their interest in your company. Consult with an attorney to determine your options. If you’re not careful, you might have an investor you weren’t expecting owning a piece of your company. 

Flexibility. Another important factor to consider is how much flexibility do you need. You will want to examine and understand your cash flow. Look into the future and try to predict if you might experience a cash crunch. If you need capital but might experience a cash crunch soon, you might want a source of capital that is more flexible in when you pay them. An investor who buys equity will be more understanding if cash flows shrink and they might not get a dividend in a particular quarter. However, with a loan, the lender will expect on-time payments under the terms of the loan. They might not be so understanding and forgiving should you be unable to pay on time. 

Risk Every decision in business has risk. Consider the risks involved with the sources of capital. Selling shares means giving up ownership and some control. The investors will also have some expectations. Know what those expectations are before bringing them on board. Are they looking for a consistent periodic return on their investment? Or are they willing to forego a periodic return instead of a larger return in the future? How much influence and pressure do you think they will apply to your daily operations and decision making? If you decide to take on debt, consider the terms offered by the lender. What rate and fees they are charging? What assets will be pledged against the loan, if any? How comfortable are you placing those assets at risk? Can you pay the loan off early without penalty? Understanding the risks involved with the various sources of capital will help you determine the best place to raise money.

Period. How long will you need the capital? If it’s a short period of time, acquiring debt might be a better solution. If you have trouble paying the debt off in time, you might attempt to refinance the loan later. There are also specific tax effects of borrowing money that will impact your income statement. Consider these effects as well when planning your capital structure. If the capital is needed for a long-term investment, issuing shares might prove to the be the stronger strategy.

Costs The money you raise won’t be free. There will be a cost associated with it. To determine your total cost of capital, it is necessary to combine the cost of equity and the liabilities on the balance sheet. If your company has a successful period, the bankers won’t mind as long as you’re paying on time; however, shareholders might want a piece of the profit as they have a claim of ownership. This can create headaches and strife and can be a significant cost to consider when sourcing capital. Loans can be easier to refinance than equity too. 

As your company grows, you might need to raise capital to meet your cash needs for growth. Take time and carefully consider how much control, flexibility, and cost you’re comfortable with. Each source of capital has advantages and disadvantages associated with it. 

If you’d like to learn more about determining your capital structure, reach out to me via LinkedIn or my website, www.davidnorrismdmba.com, and I’ll help you get the results you desire.