Beginning investors quickly gain a grasp of terms like earnings, growth, or dividends. Capital structure can be harder to grasp as a concept. Why does it matter and how can you use it to improve your investing knowledge?
What is Capital Structure?
In layman’s terms, “capital structure” describes who owns the company and where the money comes from.
A new company will usually do a capital raise from its initial investors and/or its founders. These investors hold shares in the company and become its owners.
Over the life of the company, it will start (hopefully) to turn a profit. Some of this profit can be kept in the company to fund future needs like investment or growth. We then call that money “retained earnings“; retained, as in “not distributed to the shareholders”.
But if the company needs more money than its cash flow and retained earnings can provide, it needs to find funding somewhere else. This can change where the company’s money/capital came from, which is called its “capital structure“.
The obvious option is to simply raise more money. The company can create new shares and sell them to anyone who wants to buy them. This costs the company “nothing”. The issue is that it dilutes previous shareholders.
👉 For example:
The company has only 4 shareholders, each owning 250 shares of the company. The total 1000 shares of the company are worth $1M ($1,000/share).
The company is growing quickly and needs $4M for a new factory. It can in theory issue 4,000 new shares, sell them, and raise the money it needs, especially if investors are optimistic about its new factory plans and willing to buy the shares.
The previous shareholders used to own 25% of the company each. Now, they only own 250 out of 5000 total shares, or 5% of the company’s total. They have been diluted 5-fold.
The capital raised cost “nothing” for the company – there was no cash outlay – but it comes at the expense of the pre-existing shareholders.
Dilution can be a real problem. It only makes sense for the previous shareholders to accept it if the company’s value increases faster than the dilution. This can be true only if the investment made with the raised money is profitable.
It also means the original investors may lose control of the company, as other shareholders may gain a majority interest.
A capital raise makes sense only if the Return On Invested Capital (ROIC) is good and if there is no other option.
This is a common strategy for not-yet profitable startups. The danger is that dilution sometimes doesn’t end.
🚩 Here are some capital raise red flags:
- The company is unprofitable, with no clear path to profitability. There is a risk the raised capital may just be “burned” on unprofitable activities until even more dilution happens or even bankruptcy.
- Management is overpaid. Management’s salaries or administrative costs might be too high. This might indicate the management does not have the shareholder’s interests in mind, but their own. Remember, such capital raise costs “nothing” for the company, but can hurt shareholders badly. Using it to fund oversized salaries is both unethical and a massive warning sign.
- Management receives A LOT of shares. Sometimes, management is overpaid by receiving too many shares or stock options as part of their salary. While a little will give them the incentive to boost the stock price, too much will dilute the existing shareholders, while allowing metrics like cash flow to keep looking good.
More on stock options being actual expenses here.
- Share prices are down a lot. A capital raise will be dependent on current share prices, so depressed share prices will make the dilution much worse. A company doing capital raise during a downturn is likely fighting for survival and did not have enough money set aside.
Debt is an alternative to a capital raise. Debt does not cause dilution of shareholders. Instead, the company has to promise to pay back the money in the future. Debt is usually raised through bonds.
The company receives a sum of money (the principal) and agrees to pay it back at a pre-determined date. They also pay interest every year.
👉 For Example:
So, with a 5-year bond issue worth $1M with a 5% yield, the company will receive $ 1 million.
It will pay back $50,000 every year in interest and pay back $1M at the end of the 5th year.
The interest rate a company is paying is a key element in assessing debt. Stable companies with strong financials receive high ratings from bond rating agencies and can sell bonds at low interest rates. Less stable companies may be given lower ratings and have to pay high interest rates.
☝️ Bond ratings can make a huge difference in interest costs. As of October 2022, AAA-rated corporate bonds carry an interest rate of 4.85%. “Junk bonds” with a Ba rating or below pay an average of 8.8%. That difference has a huge impact on the interest cost of a loan.
Most companies of a certain size maintain a certain level of debt. They “roll over” the debt by selling new bonds to replace the one expiring, instead of ever paying back the principal.
In theory, debt is preferable for existing shareholders as it does not cause any dilution. The danger lies elsewhere.
The company has to pay back the debt at a fixed date. Failing would mean bankruptcy. And in a bankruptcy, the owners of the debt (bondholders) are the first to be paid back, BEFORE the shareholders get anything.
The danger with debt is also that interest payments can eat up a lot of the company’s cash flow. This is money that could instead be reinvested into growth or staying competitive.
So debt can increase profitability, but also creates risks.
👉 Here are some debt essentials:
- Debt can increase a company’s profitability. This happens if the interest on the debt is lower than the Return On Invested Capital (ROIC). If the debt has a 5% yield, but ROIC is at 20%, the company makes $4 for each $1 “lost” to interest payments.
- In a period of rising interest rates, debt becomes a double-edged sword. Locking in low capital costs at a lower rate can be a good thing. That’s an incentive to get this money now before it costs more, especially if you know you will need it for new projects. But if you need to roll over the debt later, the much higher interest will be very costly and even dangerous.
- Taking on debt to pay dividends or buy back shares is generally a bad idea. Debt should be put to productive use to outweigh the costs of interest. Spending it on distribution to shareholders hollows out the capital structure and can put the company’s survival at risk.
Capital Raise or Debt?
Overall, I would say that in most cases, a little bit of debt at a reasonable interest rate is preferable to capital raises. It increases the leverage of the company, which can boost its financial performance.
This is not always possible. For example, maybe the company cannot find anyone willing to lend it money at a reasonable interest rate. This is the case for most fast-growing startups, which are yet to demonstrate the ability to turn profitable. More risk-tolerant investors can then step in and buy the new shares and fund the company’s growth.
Too Much Debt?
Too much debt can also be a problem. This is especially true in very competitive or cyclical industries or if the company’s bonds carry a low rating and a correspondingly high interest rate.
If there is a downturn in business lasting for years, rolling over the debt might be very costly or even impossible.
This is even worse if profitability declines because of competition. Interest costs will hinder the company’s ability to invest in solving the competition problem. This can create a downward spiral, where less profit means less investment. This leads to a worse competitive position, causing even fewer profits and so on.
Strategic and Well-Timed Capital Raises
One circumstance where issuing shares to raise capital might make a lot of sense is if the stock price is overvalued. This happens rarely in real life, but good management should be able to raise money when the stock is overpriced and buy back shares when it is undervalued.
Sadly, in practice, most management teams get instead over-enthusiastic about the future when stock prices (and their stock option values) rise, and do the exact opposite.
There is no ideal capital structure. Each company should be judged depending on its circumstances.
As a rule of thumb, the more unstable or cyclical the industry, and the more competitive the sector, the more debt should be kept at a minimum. Companies that are not able to achieve a high bond rating and a low interest rate should also minimize debt.
At the same time, too little debt and an over-reliance on selling shares to raise capital can badly hurt the interests of existing shareholders. It can also put the interests of management over what is good for the actual owners of the company, the shareholders.
The single most important factor in assessing a change in capital structure is whether the company has the ability to use the money to generate profits. That requires an effective assessment of the company’s competitive position and management skills.
To add to the complexity, the macroeconomic environment plays a role as well. We are currently in a rising rate environment, after 40 years of decline. This means that companies that got used to just rolling over debt might suffer from suddenly much more expensive interest expenses.
In this context, companies that are more vulnerable to the business cycle should reduce debt and deleverage sooner than later.
On the opposite, very stable and profitable companies might be better off raising money now, ideally with very long duration bonds of 10 years or more. This will give them plenty of cash and lock in low-interest rates. That cash can later be used for example to acquire cheap assets from distressed competitors that did not anticipate a downturn properly.