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The new era of risk analysis and its impact on capital structure

February 27, 2024
5 min read
re:cap_Capital structure

How does the analysis and optimization of the capital structure differ for companies in various stages and with different business models? Access to different capital instruments, and thus the ability to optimize one's own capital structure, is easier for companies with conventional collateral (asset-heavy) than for those accessing intangible assets (asset-light). Yet, a paradigm shift in risk analysis and access to alternative financing instruments is happening – and asset-light businesses benefit from it.

The rise of alternative financing options and thus also new risk assessments provide tech companies with greater flexibility in capital structuring. They can add debt earlier to their capital structure. These alternatives offer tailored solutions that align with the unique cash flow dynamics and growth trajectories of tech and SaaS companies, complementing traditional equity.

While optimizing capital structure remains a challenge for asset-light companies, the advent of new risk assessment methodologies and financing solutions is revolutionizing this landscape. By embracing these advancements, those companies can navigate the complexities of their industry more effectively.

First, let's take a closer look at the principles of capital structure.

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Definition: What is capital structure? 

The capital structure, or capital stack, delineates a company's blend of equity and debt, featured on the liability side of its balance sheet. It serves as a blueprint for how the company organizes and replenishes its financial reservoirs.

A high proportion of equity generally indicates a good capital structure. The company is financially sound, the assets are backed by equity. Conversely, high liabilities may indicate that the assets do not belong to the company itself, but to third parties (e.g., banks). However, in practice, the evaluation of the capital stack is also based on other factors.

From their capital structure analysis, companies discern the optimizations necessary to enhance appeal to capital providers and reduce capital costs. Financial institutions and investors gauge investment risks and determine terms and conditions based on an evaluation of the capital structure.

Calculation of capital structure

The capital structure is calculated using the following formula: (Equity / Debt) x 100.

It describes the vertical capital structure and compares equity and debt to the total capital of a company.

In contrast, the horizontal capital structure describes whether equity covers fixed assets and debt covers current assets.

There are specific formulas for each:

  • Horizontal capital structure I = (Equity / Fixed Assets) x 100
  • Horizontal capital structure II = (Debt / Current Assets) x 100

Capital structure ratios

Equity Ratio, Debt Ratio, and Debt-to-Equity Ratio: These ratios allow for a deeper analysis of a company's capital structure.

  • The equity ratio is calculated as: (Equity / Total capital) x 100
  • The debt ratio is calculated as: (Debt / Total capital) x 100
  • The debt-to-equity ratio is calculated as: (Debt / Equity) x 100

Analysis of capital structure

Determining whether a company possesses a favorable or unfavorable capital structure lacks a universal answer. There exists no one-size-fits-all solution or prescribed ratio between debt and equity. Each company necessitates individual scrutiny. The efficacy of capital allocation hinges upon:

  • Company goals
  • Industry dynamics 
  • Company stage 

In essence, companies, or their CFOs and financing executives, must craft a financing mix that aligns with their strategic objectives at any given juncture, while concurrently fostering financial adaptability and restraining capital costs within reasonable bounds. Consequently, the capital structure is not a static entity but evolves in tandem with a company's progression. Nonetheless, it should embody robust adaptability and resilience.

A prevalent guideline in financing principles revolves around the debt-to-equity ratio, which might be, for instance, 1:1, 2:1, or 3:1. Any deviation from the target ratio prompts the need for optimizations.

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Capital structure: debt-to-equity ratio could be a financing principle to use.

Impact of the business phase on the capital structure

The influence of the business phase on the capital structure is significant. Before a company builds its capital stack, it must secure suitable access to capital. The range of options for procuring debt or equity capital shapes the capital structure.

Let's look at capital allocation. Investors analyze a company's risk profile to determine the likelihood of getting their investment repaid. Equity financing typically entails a higher risk profile, translating to greater potential for higher returns compared to debt financing. Consequently, equity tends to be more costly than debt.

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Different stages, different demands.

Early stage: one-sided capital structure

During the early stages, companies grapple with numerous uncertainties such as hiring, product development, and market penetration, thus bearing higher investment risks. Given their elevated risk profile, typically characterized by a high-risk, high-return dynamic, equity capital emerges as the primary avenue to fortify their capital structure.

Growth phase: more flexibility

For companies that have passed this early stage and are generating regular revenues, the capital structure may look different. While equity remains foundational, the inclusion of debt financing becomes viable. This initial diversification of the capital structure diminishes reliance on a singular capital source, affording the company greater latitude in allocating various types of capital to different investments.

Established companies: various options

Established firms boasting a robust customer base and stable revenues enjoy a multitude of options. They can self-finance investments from internal resources or tap into external capital providers. Accessing loans from banks becomes more feasible, and depending on their legal structure, they may even venture into refinancing endeavors within the capital market.

Impact of the business model on the capital structure

Capital allocation and, consequently, the structure of capital are not solely contingent on the company's stage of development. Another pivotal aspect is the business model and the collateral associated with it. 

Companies endowed with physical assets such as real estate, machinery, or fleets typically find themselves in a position to integrate debt into their capital structure at an earlier stage. The risk assessment of traditional banks and financial institutions are tailored around these tangible assets. Such business models are often categorized as "asset-heavy."

"Asset-light" or "Asset-heavy" affects the capital structure

For companies with an "asset-light" business model, the landscape is notably different. Unlike their counterparts with tangible assets, they lack physical assets to serve as collateral. Instead, their collateral is intangible assets such as software products, customer contracts, and recurring revenues.

This distinctive form of collateral places them beyond the purview of traditional debt providers' risk assessments. Traditional lenders struggle to evaluate such intangible assets, often leading to reluctance in extending debt capital to "asset-light" business models.

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Not in favor with classic debt providers: tech companies focus on intangible assets.

Consequently, the accessibility of debt capital becomes a challenge for tech- and digital-savvy companies. They find themselves less able to incorporate debt into their capital structure and thus rely more heavily on equity financing, necessitating the sale of company shares.

New approaches in risk analysis

To effectively assess the risks associated with such business models, novel risk analysis methodologies and a reevaluation of the risk-return profile are imperative. These modern approaches are founded on daily-calculated data and tailored metrics. Modern debt providers prioritize insights into revenues, cash flows, accounting practices, and customer bases to make informed lending decisions.

One groundbreaking aspect of these new risk approaches is the provision of access to debt financing at earlier stages of a tech company's lifecycle. Historically, they have primarily relied on equity financing due to the perceived riskiness of their ventures. Yet, by utilizing sophisticated risk assessment models, modern funding providers can offer debt tailored to the specific needs and risk profiles of asset-light businesses, enabling them to access capital more efficiently.

Moreover, these innovative risk assessment approaches enable tech and SaaS companies to demonstrate their creditworthiness more effectively. By incorporating non-traditional metrics, alternative funding providers can gain a comprehensive understanding of a tech and SaaS company's growth potential and mitigate perceived risks.

The early access to debt financing afforded by these new risk assessment methodologies empowers tech and SaaS companies to diversify their funding sources and optimize their capital structure strategically.

How to optimize capital structure 

For a company to even be in a position to optimize its capital structure, it also depends on the factors mentioned above. However, when the optimization of the capital structure is on the table, it can proceed in the following steps:

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1. Analysis of the current situation

The initial step involves conducting a thorough assessment of the present circumstances. This entails identifying the strengths and weaknesses inherent in existing sources of financing. Such an evaluation encompasses an analysis of financial statements, cash flow projections, and credit terms. The overarching objective is to ascertain the prevailing capital costs, debt levels, and liquidity position.

2. Setting objectives

The second phase in optimizing a company's capital structure revolves around establishing goals that harmonize with the strategic objectives and risk profile of the organization. This entails conducting a comprehensive evaluation of diverse scenarios and meticulously assessing the trade-offs between debt and equity options.

3. Implementing measures

The third step is to implement an action plan that guides the company from the current situation to the goal. This may involve various measures:

  • Repayment of debts or refinancing
  • Increase or decrease in equity
  • Optimization of working capital
  • Sale of assets or M&A

4. Risk management

The fourth step involves managing risks and opportunities that may arise from the new capital structure. 

Risks may include:

  • Interest rate risks
  • Credit risks
  • Covenants
  • Refinancing risks

Opportunities may include:

  • Lower capital costs through diversification of total capital
  • Higher profitability through leverage effects
  • Improved competitive position enabling strategic investments

Conclusion: capital structure continues to evolve

The fundamental tenets of a robust capital structure remain consistent across all companies: it should embody resilience, flexibility, and alignment with organizational objectives. However, the dynamics of the capital stack and how companies interact with it are contingent upon their stage of development and business model.

In the early stages, companies encounter limitations in shaping their capital structure. Securing debt capital proves challenging, compelling them to primarily rely on venture capital and other forms of risk financing.

Yet, as they progress and attain further growth milestones, avenues for diversification emerge. With maturity comes an enhanced ability to shape the capital structure to better suit evolving needs.

Traditionally, "asset-light" companies have grappled with hurdles in diversifying their capital structure due to the intangible nature of their assets. However, recent years have witnessed a transformative shift. Emerging debt providers have pioneered risk assessment methodologies capable of appraising intangible assets as viable collateral.

Consequently, particularly in sectors like technology, digital services, and Software as a Service (SaaS), these companies now enjoy improved access to debt capital.

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