Capital refers to the funds a company has available to fuel growth and expansion. A corporation can obtain capital from equity sources such as venture capital firms or from lenders such as commercial banks. Some companies elect to do an initial public offering, or IPO, which allows them to sell stock shares to the public, including small investors. Capital structure refers to the types of capital sources a company uses and the percentage of its total capital obtained from each.
Optimal Debt/Equity Mix
The relative percentages of debt and equity capital usually change as the company grows. In the long run, debt capital is less expensive than equity. Equity capital is normally the source used by very early-stage companies that do not have the cash flow to make debt payments. Investors who provide equity expect to receive a higher rate of return than lenders would. This higher return is their reward for taking the risk that the company will not succeed. As a company grows and becomes profitable, it can obtain more of its capital from debt sources. This allows the company’s owners to hold onto their equity shares rather than having their ownership diluted by additional investors coming in.
Reasonable Debt Payments
Sources of debt capital, such as commercial banks, require that funds be repaid at a fixed schedule along with interest. Debt payments that are too high for the company’s cash flow to support can cause a strain on the company’s finances. In extreme cases, the company many not be able to fund important business functions that will help it grow, such as expenditures on new equipment to improve operating efficiency or marketing programs to increase revenues. Companies should have relatively stable cash flows before taking on debt and be able to make the required payments while still having a healthy cash balance in place.
All companies require capital to fund operations and expansion plans. Early stage companies often struggle with determining how much capital they need. Not having enough capital when you start a business makes it much more difficult to succeed. It usually takes longer to build a profitable company than entrepreneurs anticipate. Sufficient funding must be in place to keep the company going through the difficult start-up stage. Having too much capital at the outset can also cause problems. It may lead to wasting funds on unnecessary expenditures such as high priced office space. Entrepreneurs also must consider that equity capital comes with a price. You have to give up a piece of your company for the equity capital you receive. Bringing in more capital than you need means giving up a greater percentage of the company than you need to.
Accommodates Next Stage
A company often acquires capital in stages throughout its life cycle. The company’s initial capital structure can affect its ability to bring in the next stages of capitalization. Conflict can arise between the original shareholders and potential new investors over the issues of stock valuation and percentages of ownership. Existing shareholders may find their ownership percentage diluted when new investors are added. If management’s share is diluted below 50 percent, they can effectively lose control of the company to the investors. One of their goals of being in business for themselves -- autonomy -- won’t be realized.