Financial Structure

The term "financial structure" refers to the specific mixture of long–term debt and equity that a company uses to finance its operations. Why it matters? The composition directly affects the risk and value of the associated business.

First, a little about the choices. Equity represents ownership in the company, usually in the form of stock. Debt represents loans.

A company doesn't have to pay back stock. There's no cost, per se. The shareholders make money when the price of the asset (the company) rises in value.

Debt has to get paid back. Also, there's a cost to having debt, in the form of interest. The company has to write regular checks to repay the debt (think about your monthly mortgage payment and you'll get the idea).

But bringing in debt doesn't dilute your ownership. The more shares sold to outsiders, the less of the company the original founders own. Sell enough equity and the company's founders no longer have much say over "their" company.

So debt and equity both have pluses and minuses. A financial structure with too much debt gets expensive. Take on too many loans, and the regular payments of interest and principal cut deeply into operating profit. The company can't afford to do much other than service the debt.

Meanwhile, weight your financial structure too far toward equity and you can cease to own "your" company.

You found a company, holding 100% of the equity. You sell half to fund expansion. Now you own 50%. You don't care too much because you're still the largest single shareholder, plus you used the money you made selling stock to expand your business. The 50% of the your new, expanded company is worth much more than the 100% of the small startup you had before.

You want another round of expansion, so you sell half your stock again. Now you own 25%. Try the process again...12.5%.

You keep going until the company itself is very big, but you own a vanishing part of it. Eventually, you get in a tiff with some members of your board and you're asked to leave (See: Steve Jobs, circa 1985).

Why take any of these risks? Because companies need money for expansion, to build factories or hire sales people. Taking on debt or selling equity allows small garage startups to become multi-billion dollar global behemoths.

But balancing the financial structure is a key concern of corporate managers. They want to keep the cost of capital down, while making sure that their shareholders don't revolt due to excessive dilution.