Business debt and equity are central to the operations of any company. The amount of debt and equity a business carries has a major impact on how the business operates, and on how it is positioned for success. Business capital is the money a company uses to purchase assets, maintain operations, and grow (learn about the differences between working capital and growth capital here).
Business capital can be acquired in the form of debt or equity, depending on the business’ strategy. And the business capital structure is essential to the ultimate success of any business.
Debt Capital Structure
When business capital is obtained in the form of debt, it means the business has taken out a loan or other type of credit that must be repaid in the future, usually with interest.
Debt can come from private or public sources. Private sources include friends and relatives, credit unions, banks, commercial and consumer finance companies, insurance companies, among others. Public sources include a number of loan programs provided by states and the federal government for the purpose of helping small businesses. (Learn more about SBA Business Lending here.)
Forms of Business Debt:
Line of Credit
Shareholder, Member or Partner Loan
Inter-company Loan or Notes Payable
Convertible Debt Instruments
Several Forms of Business Equity:
Shareholder, Member or Partner Capital
Shareholder, Member or Partner Additional Paid in Capital
When business capital is obtained in the form of equity, the business has likely issued ownership in the company in exchange for funding. Most commonly, this happens in the form of stock (hence the term “stock equity”). Investors may be anyone ranging from friends and family to wealthy angel investors or large corporations.
There are two primary methods to issuing equity: the private placement of stock with investors or private capital firms, or public stock offerings (IPOs). Thanks to a fairly simple process, private placement is more common among small businesses and startups. In order to launch a private placement of stock, business owners need only comply with a number of state and federal securities laws. They are not required to register formally with the Securities and Exchange Commission – the way a public stock offering requires.
Forms of Business Equity:
Shared Stock (Common Stock)
Accounting for Business Capital Structure
Business capital is recorded on the Balance Sheet in the business’ financial statements in either the Liabilities or Equity Section. If the form of capital is debt, it is recorded in the ‘Liability’ section. If the form of capital is equity, it is recorded in the ‘Equity’ section.
How business capital is recorded when the business is in the startup stage may not matter much to an entrepreneur, however its proper recording becomes very important when additional business capital is needed and/or when the business, or its assets, are sold.
Why Business Capital Structure is Important
The reason recording business capital structure is so important is related to the rights associated with each form of capital. Generally speaking, debts are paid back to lenders before equity is paid back to investors. And when additional capital is being sourced, lenders and investors want to have preference over others who have provided capital to the business, if at all possible.
It’s much easier to obtain business debt to maintain and grow a business when equity was the initial form of business capital used in the startup, as opposed to debt. Equity financing doesn’t require a repayment of any debt, allowing the owner to reinvest profits back into the business. It also doesn’t require the business to make monthly payments to its owners which improves the business cash flow and its ability to meet day-to-day operating expenses.