What is Capital Structure? Why does it matter?

[Joe Latson]

Hey BP! 

Hope this is helpful for some and happy to dive in more re: the right capital structure for different types of business plans and investors. 

Thank you!

What is Capital Structure?

The way an investment or entity is owned and funded is referred to as its capital structure, or “cap stack” for short. One might ask, “how is this investment capitalized?”.

Broadly speaking, the capital stack consists of two components – debt and equity. Debt is effectively a loan to the investment entity, which most commonly comes from a bank or specialty-lender, but also includes other types of financing like a HELOC or even a credit card. Equity represents ownership in the investment. As such, the equity investors retain “control” of the investment and make major decisions, so long as they remain in compliance with the loan documents.

Investors use debt (sometimes called ‘financing’ or ‘credit’) because it can lead to higher investment returns on their equity and helps stretch their investable dollars further. The amount of debt incorporated into a capital stack is commonly referred to as leverage.

Debt investors benefit from a repayment priority and typically have the ability to foreclose on the collateral if the borrower defaults, therefore it is not as risky an investment as the investment of the equity investors. For that reason, equity investors demand higher returns than debt investors.

All Equity vs. Levered

Let’s say you have $60K of cash to invest in a property.

One option would be to acquire a $60K property. However there are a handful of reasons why that might not be the best option. In that scenario the capital stack would be 100% equity.

Another option is to finance a portion of the investment with debt. With moderate leverage incorporated into the capital stack, say 75%, you can afford a $240K property. Here the capital stack is 25% equity and 75% debt. You would still own 100% of the asset while only investing 25% of the required cash.

Takeaway

Like anything, it gets more complicated from here – there are many types of debt and many types of equity that are useful to understand after you grasp the basics.

The correct takeaway here is that leverage can be a powerful tool.

• It can be used by investors to enhance returns by intentionally introducing a quantifiable amount of risk.
• It allows investors to take on more or larger deals than they would otherwise be able to if limited to their readily available cash.

However, if not used responsibly, or if luck is not in your favor and the market suddenly turns against you, leverage can quickly erode returns and even worse, result in a complete loss of investment.