The Three Legs of Capital Structure: Essential Tips for Companies


The Three Legs of Capital Structure: Essential Tips for Companies


Indisputably, the ultimate goal of any business is to maximise the wealth of its investors by generating greater amounts of profit. In order for any business to have a sustainable and consistent growth in its profits, it must manage its costs efficiently and make sound decisions relating to the financing of its functions. It is out of this predominant requisite that the study of capital structure derives its importance. A business’ capital structure is arguably one of is most important choices. However, many businesses, especially startups, do not pay enough attention to the structuring of their capital requirements, often settling for quasi-equity or debt finance options more as a default/reactionary measure and less as a deliberate choice.

Capital structure refers to the proportion of debt and equity representing the total capital of the business which is required to fund the investments and day to day operational activities. Capital structure demonstrates how a firm finances its overall operations and growth through a combination of equity, debt and hybrid financing.

This article explores the three legs of capital structure –equity, debt and hybrid finance- pinpointing their various advantages and disadvantages.


Equity represents capital being provided to the company by investors in return for a proportional ownership in the form of shares. The principle is the same whether the equity finance is provided through an Initial Public Offering (IPO) or by a private equity group. Private equity can take the form of leveraged buyouts, growth capital or mezzanine financing, but only the first two are classified as equity. In leveraged buyouts, the private equity firm borrows money from banks or other lenders, and adds that money to its own funds to allow it to buy a majority stake in a company, then uses its controlling position to restructure the company and make it more valuable, so that it can sell its stake later at a profit. For growth capital, the private equity firm targets a larger, more mature company where it acquires a smaller stake, with the objective being growth rather than a turnaround. Mezzanine finance is a hybrid form of equity that is discussed further along in this article.

Currently, the Companies Act, 2015 does not prescribe the classes or types of shares which can be created by a company. This will depend entirely on the provisions of the company’s constitution (Articles of Association), or the contract pursuant to which the shares are issued. The classes of shares generally issued by registered companies are ordinary shares and preference shares. Ordinary shares represent a normal equity ownership in a company. These shares often allow the investor to vote, to receive dividends, and to receive distributions on the winding up of a company. Preference shares give the shareholder preferred treatment over the ordinary shareholders, for instance fixed dividend payments and a priority right to be repaid if the company becomes insolvent. Most equity investors will insist on preference shares in return for their contribution.

Raising capital through equity can has several advantages. It is a cheaper cost of finance than debt finance as it does not attract interest; and it frees up a company’s capital for use as working capital. Investors often bring valuable experience, managerial or technical skills, contacts or networks and credibility to the business, and are often willing to provide additional funding as the business develops and grows.

On the flipside, raising equity finance is demanding, costly and time-consuming, and may take management focus away from the core business activities. The process is rife with legal and regulatory compliance issues. Management also has to invest more time to generate regular special reports to track the trajectory of investor funds. Further, shared ownership means that some investors not only share profits, they also have a say in how the business is run, which may not always gel seamlessly with pre-existing management styles.


Debt financing is cash borrowed from a lender at a fixed rate of interest and with a predetermined maturity date. The principal must be paid back in full by the maturity date, but periodic repayments of principal may be part of the loan arrangement. The two main debt options include loans from financial institutions or other alternative providers and debt securities.

Debt is further classified into senior or junior debt in terms of its ranking in claims against the borrower. Senior debt has priority of claims; in a liquidation event, lenders holding subordinated/junior notes are not paid until senior creditors are paid in full. Junior debt, also known as mezzanine debt (aka ‘mezz debt’), subordinated debt (aka ‘sub debt’) or second lien, is like a second mortgage on a business. There is an interest rate which can increase the amount owed at maturity (Payment-In-Kind or ‘PIK’ interest) or can require cash interest payments. The loan principal (usually) is lower priority than senior debt but higher priority than equity in the event of administration or receivership. Because of this higher risk, junior debt is considerably more expensive than senior debt and tends to be provided by specialist investors like mezzanine debt funds and hedge funds.

The choice of debt is driven by various factors including price, capital market sentiment, terms and conditions and flexibility of the debt. Debt financing allows the company to retain control of the business as the lender has little say in management issues; at most the lender may require notification prior to major restructurings. Further, debt finance is an allowable deduction as an expense for tax purposes. It is also easier to plan around debt financing as the principal and interest tend to be public information; most lenders have debt repayment calculators online. This makes it easier to budget and make financial plans.

The major disadvantage of debt financing is the requirement for a high credit rating to receive financing- this might prove especially hard for small and medium size enterprises to achieve. In addition, a business that is overly dependent on debt could be seen as ‘high risk’ by potential investors, and that could limit access to equity financing at some point.

Hybrids (Convertibles)

Some loans, as well as bonds, carry special provisions that give them properties of both debt and equity. These are sometimes called hybrid instruments. Hybrid financing can come with fixed or floating returns, and can pay interest or dividends. The purpose of hybrid financing is to offer the investors the combination of the positive features of both debt and equity. An example is mezzanine finance discussed above, which is part loan and part investment, where the private equity investor is subordinated to other senior (secured) financiers but in return demands a higher rate of return/interest on their contribution.

Convertible bonds are the most common type of hybrid financing, and usually take the form of a bond that can be converted to equity. The conversion can only happen at certain points in the firm’s life, the equity amount is usually predetermined, and the act of converting is almost always up to the discretion of the debt holder.

Convertible equity usually takes the form of convertible preference shares, which is preferred equity that can be converted to common equity. Like convertible debt, convertible preferred shares convert into common shares at a predetermined fixed rate, and the decision to convert is typically at the owner’s discretion. Importantly, the value of a firm’s convertible preferred shares is usually dependent on the market performance of its common shares.

Hybrid finance is often cheaper than other forms of debt. Further, since the dividend or equity dilution is deferred, management is able to issue delayed equity and allow the present shareholders to maintain control and receive immediate benefits from profitable investment opportunities. One of the major disadvantages of hybrid financing for the investor is that it may not give as high returns as equity financing.


As a general rule, there should be a proper mix of debt and equity capital in financing the firm’s assets. The five key questions for the company to consider in capital structuring are:

a) how much control the company wishes to cede to the investor/financier: the less control ceded the better;

b) the overall cash cost of funding: the lower the better;

c) how much risk appetite to fund complex / high risk opportunities: the higher the better;

d) how high in the pecking order of repayment priorities the financier is: the lower the better;

e) burdens on business cash flow: the less the better.

A business must be careful to employ such proportion of debt whose cost does not outweigh the returns on its investment, consequently leaving a greater return for the shareholders. It is therefore important to fully understand the three legs of capital structure and their various advantages and disadvantages before settling on a preferred capital structure.

Jaqueline Wangui & Miriam Tatu