Executives expend a great deal of effort to determine the optimal way to finance the operations of their businesses. This may involve bringing on outside investors, employing bank debt, or financing through cash flow. Once the money has hit the bank, they may wonder, what effect does the capitalization of my company have on the value of its equity?
A company with a simple capital structure typically has been financed through the issuance of one class of stock (usually common stock). Companies with complex capital structures, on the other hand, may include other instruments: multiple classes of stock, forms of convertible debt, options, and warrants. This is frequent in startup or venture-backed companies that receive financing through multiple channels or fundraising rounds and private equity sources.
With various types of stock on the cap table, it is important to note that all stock classes are not the same. Each class holds certain rights, preferences, and priorities of return that can confer a portion of enterprise value to the shares besides their pro rata allocation. These often come in two categories: economic rights and control rights. Economic rights bestow financial benefits while control rights grant benefits related to operations and decision making.
Economic rights:
- Liquidation preference
- Dividends
- Mandatory redemption rights
- Conversion rights
- Participation rights
- Anti-dilution rights
- Registration rights
Control rights:
- Voting rights
- Protective provisions
- Veto rights
- Board composition rights
- Drag-along rights
- Right to participate in future rounds (pro-rata rights)
- First refusal rights
- Tag-along rights
- Management rights
- Information rights
The value of a certain class of stock is affected both by the rights and preferences it holds as well as those held by the other share classes on the cap table. The presence of multiple preferred classes also brings up the issue of seniority as certain class privileges may be overruled by those of a more senior share class.
Complex capital structures require complex valuation models that can integrate and prioritize the special treatments of individual share classes in multi-class cap tables. As such, models such as the PWERM or OPM are better-suited for these types of circ*mstances.
Originally published in theFinancial Reporting Update:Equity Compensation, June 2019.
FAQs
A company with a simple capital structure typically has been financed through the issuance of one class of stock (usually common stock). Companies with complex capital structures, on the other hand, may include other instruments: multiple classes of stock, forms of convertible debt, options, and warrants.
How do you tell if a company has a simple or complex capital structure? ›
Types of Capital Structure
As outlined above, a simple capital structure does not contain any securities that could potentially dilute the company's earnings. In contrast, a complex capital structure contains securities that could potentially dilute the company's basic earnings.
What is the most optimal capital structure? ›
The optimal capital structure of a firm is the best mix of debt and equity financing that maximizes a company's market value while minimizing its cost of capital. In theory, debt financing offers the lowest cost of capital due to its tax deductibility.
What makes a complex capital structure? ›
What Is Complex Capital Structure? The use of different forms of securities, rather than relying solely on one class of common stock. A company with a complex capital structure might have a combination of several different varieties of common stock classes—each carrying different voting privileges and dividend rates.
What is an example of a simple capital structure? ›
Key Points from the Example:
CleanGreen Inc. has a simple capital structure since it only has common stock and no other potential common stock instruments. The calculation for earnings per share (EPS) is straightforward and only requires the basic EPS computation.
What is the difference between simple and complex capital structures? ›
A company with a simple capital structure typically has been financed through the issuance of one class of stock (usually common stock). Companies with complex capital structures, on the other hand, may include other instruments: multiple classes of stock, forms of convertible debt, options, and warrants.
How to determine the appropriate capital structure of the company? ›
Some main factors include the firm's cost of capital, nature, size, capital markets condition, debt-to-equity ratio, and ownership. However, these factors might help to choose an appropriate capital structure for a business, but checking all the side factors can help adopt more appropriate and accurate adaption.
What are the 4 types of capital structure? ›
The types of capital structure are equity share capital, debt, preference share capital, and vendor finance. In addition, it ensures accurate funds utilization for business. The right capital structure level decreases the overall capital cost to the highest level. Also, it increases the public entity's valuation.
How to determine capital structure? ›
Analysts use the D/E ratio to compare capital structure. It is calculated by dividing total liabilities by total equity. Savvy companies have learned to incorporate both debt and equity into their corporate strategies. At times, however, companies may rely too heavily on external funding and debt in particular.
What are the determinants of capital structure complexity? ›
These factors include a firm's dependence on external financing (need for financing), access to the credit market, and ability or capacity for additional borrowing. We use several proxies to measure the impact of the above factors on the complexity and concentration of capital structure.
Capital structure refers to the mix of different sources of funds, including equity and debt, used by a company to finance its operations and investments. It represents the way that a company finance its assets and is essential in determining its financial health and risk profile.
What are the three 3 main parts in capital structure? ›
The Capital Structure is the mixture of debt, preferred stock, and common equity used by a company to fund its operations and purchase assets.
What is the simple example of capital? ›
These assets may include cash, cash equivalents, and marketable securities as well as manufacturing equipment, production facilities, and storage facilities. In the broadest sense, capital can be a measurement of wealth and a resource for increasing wealth.
How to determine the capital structure of a company? ›
The formula to determine a company's capital structure, expressed in percentage form, is as follows. Where: Common Equity Weight (%) = Common Equity ÷ Total Capitalization. Debt Weight (%) = Total Debt ÷ Total Capitalization.
How do you identify a firm's capital structure? ›
A company's capital structure constitutes the mix of equity and debt on its balance sheet. Though there is no specific level of each that determines what a healthy company is, lower debt levels and higher equity levels are preferred. Various financial ratios are used to analyze the capital structure of a firm.
How do you interpret a company's capital structure? ›
In evaluating a company's capital structure, the financial analyst must look at such factors as the capital structure of the company over time, the business risk of the company, the capital structure of competitors that have similar business risk, and company-specific factors (e.g., the quality of corporate governance, ...
How do you determine corporate structure? ›
Sources such as annual reports and offering prospectuses can shed light on corporate structures.
