Double Clicking on your Startup's Capital Structure

Imagine you're a gardener with a flourishing startup as your vibrant garden. To ensure your entrepreneurial oasis thrives and blossoms, you need diverse capital, much like a variety of nutrients that invigorate your plants.

Choosing the optimal capital structure or capital stack, the mix of equity and debt, for your company is crucial for maximizing its value and minimizing the cost of capital. Depending on the stage of business and the industry you operate in, you will need to choose how much equity, preferred equity, mezzanine debt, and senior debt you want to fund your startup. 

A well-balanced capital structure can help your startup achieve financial flexibility. It is also an important determinant to maintain good credit rating and attract investors and lenders. On the other hand, a poorly designed capital structure can expose you to financial distress.

Why is the optimal capital stack important for your startup?

A startup already has a ton of challenges to overcome. Making the wrong decision about financing can dig you into a deeper hole. The optimal capital structure will ensure you survive the initial stages of turbulence. 

A well-structured capital stack will ensure that you have financial agility to seize the right opportunities. For instance, if the right talent comes along that can catapult your business to success, having picky venture capitalists can stall that recruitment. You may have more flexibility hiring the talent you want with debt capital.

Another reason to give your capital stack thought is to manage risk effectively. Relying only on equity financing will lead to diluted ownership. On the other hand, too much debt financing can strain cash flow since you will have repayment obligations to manage. Striking the balance between equity and debt spreads risk across different funding sources.

Perhaps the biggest reason to focus on capital structure is to optimize your cost of capital. Too much debt can weigh you down in the early stages of functioning. Similarly, giving up a big portion of your equity can leave you with limited control. It’s best to think about how much stake you want to retain in the company and choose a mix of equity and debt financing that can help you reach your goals without ballooning repayment obligations or too much equity dilution.

Why debt is an essential component of startup capital structure

Many entrepreneurs tend to shy away from debt when they start out. They think that debt is too risky, too expensive, or too complicated to manage.

They may also believe that equity is more attractive, as it does not require fixed payments and signals confidence to the market. However, these assumptions may often overlook the benefits of debt for startups.

Debt can be a great choice for entrepreneurs who do not wish to dilute the ownership or control of the company. The company does not have to share its profits or decision-making power with other investors, as it does with equity. Debt financing can be cheaper than equity in the short term, as the interest payments on debt are tax-deductible and the principal amount is fixed.

Debt financing can also signal confidence and credibility to the market, as it shows that the startup can generate enough cash flow or income to service its debt obligations.

If outright debt doesn’t seem like your cup of tea, alt-financing debt capital can be an alternative to consider. These are non-traditional financial sources that can help you raise money without diluting equity or paying too much interest. For instance, revenue-based financing allows you to borrow money against your current or future revenue and pay it back in installments. This works well for startups with steady and recurring revenue, such as SaaS or e-commerce.

You could also consider invoice financing or crowdfunding. The former allows you to cash in unpaid invoices by selling them to a third party, who pays them upfront (minus a cut) and chases the customers for payment. Crowdfunding is like asking the whole world to chip in for your awesome startup idea. You can give them a piece of your pie (equity) or a thank-you gift (debt) in return. This can be suitable for startups that have a strong social or environmental impact, a loyal customer base, or a unique product or service.

If you have already received venture capital, venture debt is another option on the table.

What’s the difference between securing venture capital and debt financing?

Depending on where your business is at, you need to evaluate whether venture funds, debt financing or a combination of both are the best choice of funding for you. As such, there are some differences in eligibility.

Venture capitalists typically fund early-stage or high-growth companies that can exhibit potential for rapid expansion and scalability. Think innovative products, technologies, or business models that are potentially disruptive.

Some other things that VCs look for are startups that demonstrate a large addressable market and the potential for substantial returns on investment. They also look for a solid management team, talent and the people driving the organization.

The requirements for debt financing are more flexible – a track record of stable cash flows and a history of generating profit are usually the primary requirements. Collateral or assets can often be used to get a higher amount. Typically, debt financing is easier for startups that have been around a while and can prove creditworthiness plus good financial health.

If traditional sources of debt are not an option, alt financing can help secure the funds that you need to run your startup. 

How to deploy equity or venture financing effectively?

The priorities of an early-stage startup are very different from that of an established business. In your initial months or years, there are two core areas you should focus on – product or service and sales.

Product development is at the heart of business success. It’s imperative that you channel most of your capital into developing a minimum viable product. At this stage, it may be hard to get equity or venture funding. Traditional debt may be a better idea. You can use the debt funding for market research, purchasing equipment, recruiting your initial team, screening and testing, and modifying your product. If your idea is truly remarkable, you could also turn to crowdfunding or financing from friends and family.

Once you have a minimum sellable product, sales generation must become a priority. You’ll find that a bigger portion of your capital and resources will go towards connecting with potential clients and closing sales. 

At this stage, equity financing can become viable. When investors see market interest in your products, they will be more willing to jump in with their money. You can then use the funds to expand your sales team, marketing budget and other expenses required to keep your startup growing. You could also consider alt-financing once your revenues stabilize.

One caveat to keep in mind is that as you deploy startup funds to get your business off the ground, be wary of overspending on pricey executives too soon. Of course, the right talent can help you grow your business, but high-salary hires are best deferred until you can afford them. If you absolutely do want them on your team, try and incentivize equity over outright cash payments. For the first few months, it is best to run shop with essential positions.

How to choose the optimal capital structure for your startup

The optimal capital structure for a startup is not a fixed or universal formula, but rather a dynamic and context-specific one. It depends on the trade-offs between the costs and benefits of debt and equity financing, as well as the preferences and expectations of the founders and investors.

As a startup, you should consider your business's current and future needs, opportunities, challenges, and goals when choosing its capital structure, and be ready to adjust it as it evolves and grows over time.

If you are a budding entrepreneur and need a small amount of financial boost, debt could be a good option. This can be a faster and cheaper way of raising funds without giving up any ownership or control of the business.

If you need higher financial support for your business expansion or other such reasons, then equity financing makes a befitting choice. This can be a more attractive way of raising funds considering your needs, as it does not require any repayment or interest payments, and provides more working capital that can be used to grow the business.

​​How to maintain an optimal capital stack?

Managing your capital stack requires you to keep an eye on your cash flows. This involves monitoring and projecting cash inflows and outflows, implementing effective working capital management practices, and maintaining adequate liquidity to cover debt repayments.

Effective debt servicing will require you to set aside a portion of your cash flows to make timely interest and principal repayments. You could do this via effective financial planning and budgeting processes, ensuring sufficient cash reserves are available for debt payments, and maintaining open communication with lenders.

While servicing debt, it is essential to maintain a healthy equity position to absorb unexpected financial shocks and maintain financial flexibility. Equity management is a beast of its own.

When raising equity capital, it's important to carefully manage the dilution of existing shareholders. To maintain optimal capital structure, you should consider the impact of equity issuances on the ownership distribution. Another important consideration to make is your dividend policy. Take time to understand how to balance reinvestment in business with returns to shareholders to maintain optimal capital structure.

Ignoring the capital stack of your startup in the early stages of business can be detrimental to your success. Poor capitalization can be expensive, risky and hinder your cash flow. One wrong decision can put you in too much debt or rid you off your ownership completely. Finding the optimal capital structure can make all the difference in your growth journey.

While you leverage these various capital sources optimally to fuel your company’s growth, managing and communicating with your stakeholders is extremely important. Qapita offers an integrated equity stack management solution to digitally maintain your captables and ESOP programs and communicate with your shareholders and ESOP holders effectively.

And yes, if you are looking for smart capital, join Recur Club, the smart financing solution for all businesses from startups to small and medium businesses. What are you waiting for?