Capital Stack

Foreword

How do business ventures get funded? Who’s paying for the overhead when the company is first starting out and has no revenue? And what do they get out of this?

As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.

If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.

Decent proposal

Let’s say you have a fantastic new business idea, but to get the business started will require $50,000 right now, which you do not have. How could you fund your new venture?

Traditionally, there are 2 main avenues:

1. Take a loan from a bank
2. Take on some partners who have deeper pockets (i.e.: sell a portion of your new company)

The former is also known as debt financing, and the latter is equity financing.

When you take on debt, you agree to pay the lender some amounts of money on some fixed timeline. For example, 1% of the loan amount every month (interest payment), and then 100% of the loan amount at the end of 10 years (principal payment).

When you take on partners, they share in the profits (or losses!) of the entire enterprise. So, if after paying off all your bills (which may include debt payments), you are left with $1,000 to distribute between the partners, then you and your partner can(1) get up to $1,000 in total. Who gets how much depends on your partnership agreement, as well as how much of the company each of you own.

First come, maybe not first served

Who gets how much money, and when, is one of the 2 central differences between debt vs equity financing.

Debts must always be paid back, on the timeline agreed upon when the loan is taken out. If you fail to make even a single payment on the debt, it is technically in default, and may officially be in default after some grace period. At that point, the lender generally has some set of rights they can exercise, up to and including forcing you to give up ownership of your company to them.

Equity partners, on the other hand, generally have no fixed payments due. A company can very well never return a single cent to the equity partners! The main considerations are the partnership agreement(2), which will detail how any payments, if made, will be distributed amongst the partners, and fairness — in general, in the absence of any details about how profits are shared, then all dividends will be made pro rata, i.e.: if each of the partners own 50% of the company, then every dollar distributed will see 50c go to each partner.

One way of thinking about this, is that debt investors have the first dibs on revenue generated by the business. Once all debt payments are made, and all other costs are paid, whatever is left over (which may be nothing, or even negative — a loss) can be distributed to the equity partners. In exchange for this “seniority” in terms of payment, debt investors typically settle for a smaller and shorter-term profit — interest rates are generally much lower than what the business can be expected to return over the long term.

Control your enthusiasm

The other central difference between debt and equity financing is that of control, or rather rights — who has rights to do what with the company?

Debt investors generally have no rights on the company other than their regular payments (sometimes known as coupons). If, however, a payment was missed for long enough that the company is in default of the loan agreement, then debt investors generally have additional rights to recover their investment, such as forcing the equity partners to give up ownership of the company, or forcing a sale of the business to 3rd parties to repay the loan.

Equity investors are generally split into 2 groups — the general partners(3) who oversee the actual running of the company, and may even be personally responsible if the company goes bankrupt, and the limited partners, who generally provide the funding for the business, but otherwise have no say in the day to day running of the company.

Mix ‘n match

When you think carefully about it, debt investors and equity investors are very similar at a very high level. Each of them:

• Provide capital for a company …
• … and, in return, receives some promise of cash flow at a future time, …
• … along with some rights with regards to the company.

And at this abstract level, it shouldn’t be surprising, then, to learn that the tradition little boxes that debt and equity investors fit in, are not nearly that clean cut in practice.

In practice, an investor in a company is labeled debt or equity based mostly on their rights to call an event of default on the company. If an investor can call an event of default on the company when their promised distribution is not received, then they are typically labeled debt investors. Otherwise, they are an equity investor.

Some examples, in order of decreasing priority when profits are being distributed (i.e.: an investor at a lower row is not paid, until all investors in higher rows are paid according to the agreement):

Senior debt	Typically the highest priority of debt investor. All coupons of senior debt must generally be paid, before anyone else sees a single cent. Due to this priority, senior debt is typically much safer than all other tiers of investors, and in many cases, senior debt investors may even have collateral — assets owned by the company which the investor can seize if the loan is in default. In exchange for these protections, senior debt tends to have the lowest interest rates (i.e.: the lowest returns).
Mezzanine debt	Not often seen, except in very large projects with huge capital requirements. Mezzanine debt are paid after senior debt, but before all else. In most cases, mezzanine debt either are exactly the same as senior or junior debt, except that they are paid in between the two. The additional carveout is almost always entirely just to provide the payment priority protection, and thus a higher interest rate than senior debt, but a lowest interest rate than junior debt.
Junior debt	When there are 2 (or more) classes of debt investors, the lowest tier is called junior debt. Junior debt typically are more risky, as they are paid only after senior/mezzanine debts are paid. Also, junior debt typically don’t have collateral. In exchange for the increased risk, junior debt tends to command the highest interest rates of all debt tiers.
Preferred equity	Preferred equity can really be anything at all — anything that you can describe in a legal contract (the partnership agreement) is probably fair game. In some cases, preferred equity share the same uncertain returns as equity, but are paid first in cases of bankruptcies (i.e.: their entire investment is returned to them, and whatever is left is distributed to the equity tier). Most commonly, however, preferred equity are very similar to debt — they get a fixed coupon that is generally at a higher rate than junior debt, and they may get a little bit extra if the business does exceptionally well. In exchange for this higher rate of interest, preferred equity gives up the right to call an event of default on the company if their coupons are not made on time.
Equity	The equity tier is typically the lowest priority in terms of distribution of profits. This means that if there isn’t enough money to satisfy the claims of all higher priority tiers, the equity tier may not get any profits at all. However, if the business does exceptionally well, then the equity tier may get a return much higher than all other tiers combined. The equity tier is also commonly known as “share holders” (or “stock holders”). When you buy and sell a stock, say GOOG, on the public markets, you are essentially trading ownership interests of the equity tier of that company.

A table where a company lists all its debt and equity investors, according to their priority in terms of payment and their contributions to the venture, is called a “capitalization table” (or “cap table” for short). A table or description detailing how the profits are actually distributed (assuming there are any profits to distribute) is called the “waterfall”.

In general, as you go down a cap table, risk increases, but potential return also increases.

To each their own

Which tier you want to invest in, is entirely up to you and your personal situation.

If you are a retiree, and you need stability of income, you may opt to give up some upside, but get more protection by going up the capital stack (i.e.: going up the rows in the cap table).

But if you are investing for the long term, and you are diversified such that your investment in a single company is a relatively small part of your entire portfolio, then it may make sense to take on the additional risks involved in the lower tiers, for a chance at a higher return — even if this particular company goes bankrupt and you lose all your money in it, hopefully, enough other companies that you’ve also invested in will succeed, such that you still make a greater return than investing at a higher tier.

In the end, where each investor ends up on the capital stack depends on their expectations of how the company will perform, as well as their personal financial situation (generally, their ability to withstand uncertain cash flow and/or losses).

Footnotes

1. “Can”, not “will”, because in most cases, distributions (or dividends) are not paid on new companies. New companies tend to be very cash hungry, as they need cash to spin up their factories, advertising, research, etc., and more cash is almost always better. As such, equity partners generally don’t tend to see a single cent of profits until years 2-3 or beyond. The exact timeline depends on the nature of the business — some cash intensive businesses may not see a dividend for decades!
2. Technically, a “partnership agreement” is only used in a partnership (this is a legal term). LLC’s (limited liability company) and corporations use “operating agreements” instead. However, for purely financing purposes, the basic principles remain the same — a group of people got together to fund the equity tier of a company, and there’s a document that describes what they can expect to get out of that venture. I’ll use partnerships for simplicity going forward. Understand that the issues discussed affects LLC’s and corporations as well, though perhaps with minor differences.
3. As with “partnership agreement”, “general partner” and “limited partner” are terms used in partnerships (the legal entity). LLC’s and corporations have different names for these roles (board of directors, executive team vs shareholders, etc.). Despite the naming differences, the roles are mostly the same and for simplicity, I’ll stick with the nomenclature for partnerships.