How to choose the right capital structure for your small business

Megan Dedekind | 11 October 2023

Megan Dedekind is an area manager at Business Partners Limited.

Much of the success of a small business relies on effective financial management. An important part of this task involves pooling any available sources of funds and planning how to use those funds to sustain ongoing operations and eventually, expand the business.

To do this, small business owners need to decide which funding or capital structure is best for their business model, their immediate and long-term needs and their future plans for growth and development.

In essence, a capital structure is a model that brings together two main sources of funds: debt and equity. Typically, most small businesses will rely on a combination of these components when financing their day-to-day operations and putting the necessary measures in place to build a robust financial framework.

Ultimately, formulating the most viable capital structure for a business is a delicate balancing act that requires sound decision-making and realistic goal-setting.

Debt, equity and hybrid capital structures

The main source of capital for small businesses that use a debt capital structure to fund their operations is money that is borrowed and needs to be repaid in instalments over a period of time.

The most common sources of debt capital include bank loans, loans from independent financiers, such as Business Partners Limited, or credit arrangements made with a financial institution.

The terms of each of these credit products will vary greatly depending on the institution, the prevailing interest rate, any collateral requirements needed to secure the loan and the repayment schedule.

An equity capital structure, on the other hand, is the ownership stake in the company that is held by its founders, investors or shareholders.

Sources of equity capital into a small business come in the form of cash injections made by the company’s founders, the contributions of investors or retained profits (returns that are reinvested into the business).

The major difference between a debt capital structure and one based on equity is that equity does not necessarily need to be repaid.

Many small businesses opt for a hybrid capital structure - a mix of debt and equity capital. This is often the most attractive and financially viable option, as it offers potential investors, founders and stakeholders the potential benefits of both debt and equity. With a hybrid capital structure, business owners can benefit from access to cash and assets connected with equity, as well as additional capital in the form of credit.

Why capital structures matter

The kind of capital structure you, as a business owner, choose will have far-reaching implications for your goals, risk tolerance and mitigation, as well as your access to financing for future use.

Capital structures can also be used as a way of making a business case for future investments. The more balanced a small business is in terms of capital structure, the more it will be able to demonstrate financial health, as well as its ability to buffer itself against market volatility, emerging risks, socioeconomic challenges and unexpected dips in profit.

Arguably, the most important factor that an optimal capital structure can enable is a large degree of flexibility. For example, a business with a hybrid capital structure may have the flexibility needed to raise debt capital as and when needed. This may be particularly useful in times of unexpected changes such as an economic recession, periods of supply chain disruptions, labour shortages, changes in government policies and competition in the market.

Tips on choosing a capital structure

There is no one-size fits all option when it comes to choosing a capital structure for a small business. There are, however, a few determining factors that could play a role in your decision, the first of which is the profitability and cashflow status of your business.

If your small business is very liquid (has easy and quick access to cash resources), it is more likely that the business will be able to afford to take on more debt and service that debt consistently.

Another aspect to consider is whether your small business has a strategic growth plan and measurable goals to determine whether that growth plan is on track.

Companies that are anticipating high growth will likely expect to take on significant capital expenditures. In order to support this high growth rate and to afford things like expensive equipment, a larger workforce, higher property costs and the like, external financing in the form of loans may be the most viable way to sustain the expansion of the business.

Your appetite for risk as a business or equity owner will also play a role in deciding which capital structure will work best.

A higher level of equity financing may help reduce the financial risk of getting a business off the ground, but it can also limit immediate growth opportunities.

Likewise, business owners who are less risk-averse may opt for a debt capital structure, based on their market forecasts and expectation of future reward.

Ultimately, the optimal capital structure for your small business will vary based on its unique circumstances and objectives. Striking the right balance between equity and debt is essential for ensuring the business's financial stability and future growth prospects.