Understanding How Businesses Are Financed
This post will explain the various options that businesses have when it comes to raising capital. It's important for small business owners to understand their options so that they can plan better and so that they are prepared to capitalize on opportunities as they arise.
The decision of whether or not to raise outside capital is less important than it is that small business owners understand how the process works. Through this understanding, better decisions can be made.
This post will explain how businesses grow organically and how to decide if outside capital is necessary. How Businesses Grow OrganicallyBefore we look at why a business would want to raise outside capital, we need to look at how they grow organically. Businesses grow organically in only four general ways:- By getting more new customers.
- By getting those customers to spend more per transaction.
- By getting those customers to purchase more times.
- Through referrals and affiliates.
These points are fairly self-explanatory. If you're interested in learning more about organic growth (as well as how businesses grow through M&A deals), we recommend this post here.
In most cases, the best option for growth is to do it out of positive cash flow. When businesses can't finance growth out of cash flow from organic operations, they can look to raise outside capital.
This outside capital can provide businesses with the ability to grow more quickly, but it comes at a cost. Understanding How Businesses Are FinancedNow that we understand how businesses grow organically, we'll look at the various ways that businesses are financed. Assets = debt + equity. Here, we'll look at the various ways that businesses can choose to finance these assets.
It's important to note that the decision to use debt vs equity is highly discretionary. One entrepreneur may be actively searching for an equity partner, while another may hate that idea.
How a business chooses to finance its assets is called its capital structure. The capital structure is a more general way of referring to how a business is financed and implies a higher-level view of the business. Capital structure breakdowns are concerned with how much of a business's asset base is financed with debt and how much is financed with equity.
Going a level deeper, we can look at the capital stack. The capital stack looks at a business's capital structure in a more granular way. The capital stack breaks a business down into three categories and then shows us the various types of debt and equity that comprise each. Generally, the capital stack is broken down into three categories:
1. Senior debt
2. Subordinated debt
3. Equity
These categories are organized by liquidity position. Senior debt has the highest liquidity position, followed by subordinated debt, and by equity. This means that in the event of a bankruptcy (where a business cannot pay its expenses), the highest liquidity positions are paid back first.
With this hierarchy of liquidity, comes corresponding risk. In the event that a business cannot pay back all of its debt, the equity investors in the business would not be paid back if the business were liquidated. So, the highest liquidity positions are considered less risky positions than the lowest. A Breakdown Of The Capital StackIn the last section, we looked at how the capital stack is broken down into senior debt, subordinated debt, and equity. Here, we'll look at the various types of debt and equity that make up each category in the capital stack.
Senior debt is typically made up of revolver debt and term loans. Term loans are what we think of when we think of traditional loans. They can be fully amortizing, partially amortizing, or non-amortizing. Term loans are paid back on fixed schedules. In exchange for lending the money, the lender gets interest payments on the loan. Businesses can have multiple term loans at the same time. Revolver debt is debt where the borrower is given constant access to a line of credit (up to the maximum amount). They will only owe interest on the amount that they borrow until it is paid back. Revolver debt is offered to businesses in the form of credit cards or lines of credit.
Subordinated debt is designed to bridge the gap between senior debt and equity. Typically, subordinated debt is made up of mezzanine debt, high-yield bonds, PIK notes, and vendor notes. Subordinated debt products are more complicated to understand and are often not available to small businesses. In mergers and acquisitions, acquiring businesses often use leverage (debt) to help them finance the purchase of another business. Mezzanine debt is typically used in the leveraged buyout process. PIK notes are loans where the borrower can make their loan repayments in forms other than cash. PIK stands for "payment in kind." Vendor notes result from vendor financing, where a supplier gives a retailer a loan in order to purchase more inventory from them.
Equity carries the lowest liquidity position. Typically, equity is comprised of common stock and preferred stock. Additionally, shareholder loans are considered a type of equity. Common stock is stock that carries voting rights. Preferred stock is stock that typically doesn't carry voting rights (but can), but comes at a higher liquidity position than common stock and often pays regular dividends. Shareholder loans are often created when owners put more money into the business without structuring this as formal debt. SummarySo far we've seen that businesses often grow organically as much as possible. If a business can't grow out of organic cash flow, it will look to raise outside capital. A business' capital structure shows us how much of a business' assets are financed with equity vs debt. The capital stack shows us a breakdown of a company's capital structure so that we can see the various types of debt and equity that are used to finance operations. The capital stack is broken down into three main categories: senior debt, subordinated debt, and equity. To learn more about the capital stack and the various types of debt and equity that make it up, we recommend this guide here.
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