Understanding the Capital Stack
One of the questions that we get asked from time to time – and a term M&A types throw around pretty frequently – is “what is the capital stack?” Simply put, the “Stack” is all of the types of capital that a company uses. For instance – all companies have equity, right? (Let’s not get to far into the weeds here – let’s assume it’s an operating company and more than a day or so old…) But other common components in the capital stack include a variety of types of equity, as well as a variety of debt instruments.
In the vast majority of small, privately held companies there are two types of capital: equity capital and debt capital.
But “debt” and “equity” obscure the fact that those items actually come in quite a number of flavors. Equity, for instance, may consist of both common equity and preferred. Debt is often broken down as well between Junior (Or Mezzanine) debt and Senior Debt. And then there is investment grade debt – i.e. bonds.
Why Does it Matter?
When structuring investments with outside sources, it often makes sense to consider a wider range of investment vehicles. For instance, it is not uncommon for VC or Private Equity funding deals to include a “slice” of preferred equity. Likewise, investors might engineer higher returns by including a mezzanine lender as part of the investment package.
Liquidation Preferences: Risk vs. Reward
In our pyramid diagram, we’ve included the most secure investments at the bottom and least secured at the top. In a bankruptcy or liquidation scenario, the common equity investors are the last to be paid out. Likewise, bondholders are first (actually, right behind Uncle Sam and Employees).
Along with risk, of course, comes reward. Common equity commands the highest rates of return. Likewise, junior debt will require steep (some might say usurious) interest rates, whereas bondholders see returns near LIBOR.
In Our World: Valuation
In the valuation world, we’ll commonly consider liquidation preferences in calculating stock option values. The reason: typically VC backed companies will begin to develop a more complicated capital stack, requiring analysis of liquidation preferences in order to ascertain the value of any given Class.
In Your World
Add the various capital types to your tool chest- and be sure to drag them back out when you consider structuring your next deal.