Company’s Capital Structure over its Life Cycle

The maturity, capital intensity, market position strength, and the stability and nature of a company’s operation are all elements that influence its capital structure and ability to support debt.

As a general rule, companies begin as capital consumers; that is, they burn cash. Cash flows then go from negative to positive, and business risk declines as they develop, allowing for greater use of leverage. At this stage, debt becomes a larger component of its capital structure. Capital markets connect companies with investors whose requirements vary. Capital that cannot be obtained through borrowing must be obtained through equity.

There is a link between a company’s life-cycle stage, cash flow characteristics, and its ability to support debt. A company’s life-cycle stages include start-up, growth, and maturity.

Capital Structure and Company Life Cycle

$$
\begin{array}{l|c|c|c}
\textbf { Stage life cycle } & \textbf { Start-Up } & \textbf { Growth } & \textbf { Mature } \\
\hline \text { Revenue growth } & \text { Beginning } & \text { Rising } & \text { Slowing } \\
\hline \text { Cash flow } & \text { Negative } & \text { Improving } & \text { Positive } \\
\hline \text { Business risk } & \text { High } & \text { Medium } & \text { Low } \\
\hline \text { Debt availability } & \text { Very limited } & \text { Limited } & \text { High } \\
\hline \text { Cost of Debt } & \text { High } & \text { Medium } & \text { Low } \\
\hline \text { Typical debt Cases } & \text { N/A } & \text { Secured } & \text { Unsecured } \\
\hline \text { Typical % of capital structure } & \text { Close to } 0 \% & 0 \%-20 \% & 20 \%+ \\
\end{array}
$$

Start-ups

In the start-up stage, companies are cash consumers. The revenue is negative, and the risk of business failure is high. Companies in the start-up stage will use equity instead of debt because of the high uncertainty of cash flow generation. In essence, such a situation makes regular debt payments difficult. This equity is sourced privately rather than in public markets.

Growth

A company generates more revenue as it exits the start-up stage. Revenue is rising, but cash flow is likely negative due to the high investments needed to achieve this growth and scale.

Business risk declines at this stage as a company establishes a customer and supplier base. The company also becomes more attractive to lenders since cash flows and asset base can be used as security. Companies will begin using debt, but equity remains the predominant source of capital.

Mature Businesses

At this stage, revenue may slow down or begin to decline. Cash flows are reliable and positive, and the company can support low-cost debt, often on an unsecured basis. From the company’s perspec­tive, debt financing is likely more attractive than higher-cost equity financing.

In practice, large, mature public companies commonly employ significant lever­age. Due to the tax-deductibility of interest expense, debt is a key component of the “optimal” capital structure once an organization can support it.

Over time, mature organizations often deleverage, decreasing debt as a percentage of total capital. Deleveraging occurs due to ongoing cash flow generation and the fact that equity values improve over time due to share price gain. Companies may choose to execute share buybacks to mitigate this deleveraging, reducing the equity in their capital structure.

Unique Situations

Capital Intensive Businesses With Marketable Assets

Regardless of their stage of development, some companies employ a lot of leverage, e.g., real estate and other capital-intensive businesses. However, some highly capital-intensive businesses (e.g., hotels, and restaurants) are now held by marketing or service organizations that have contractual ties with the owners of real estate or other fixed assets employed in the business. For example, Hilton Worldwide operates all its hotel rooms through long-term franchise agreements, while others own hotels. Conversely, some relatively large and mature businesses use little debt.

Cyclical Industries

Revenues and cash flows vary substantially over the economic cycle in cyclical sectors such as mining, materials, and many other industries, limiting debt capacity.

‘Capital-light’ Business

Some business models, particularly software-based technology enterprises, have minimal fixed investments or working capital requirements, regardless of their stage of development. They are less likely to have debt in their capital structures and significant net cash. This is because:

• These businesses are frequently cash flow positive from the start, requiring little or no fixed assets or capital investment to support growth. They never need to raise substantial sums of capital.
• Many businesses in rapidly changing industries recognize the need to save money for future acquisitions.
• Companies may not be under the same pressure to pay dividends or repurchase shares if they are fast-growing and successful.
• The market value of a company can dwarf the value of any debt that has been raised if the share price rises significantly.

Question

Which of the following is most likely a characteristic of a company’s growth life cycle stage?

1. High cost of debt.
2. Positive cash flow.
3. Medium business risk.

Solution

The correct answer is C.

Medium business risk is a characteristic of the growth stage of the company life cycle.  This is because, at this stage, a company’s revenue is growing, and it is establishing a customer and supplier base. Cash flow may still be negative due to the high investments needed to achieve growth.

A is incorrect. The high cost of debt is a characteristic of the start-up stage of the life cycle. This is because start-ups don’t have assets to secure debt facilities. Additionally, cash flows are negative as companies in this stage are consumers.

B is incorrect.  Positive cash flows are a characteristic of the mature life cycle stage. At this stage, a company has stable revenues since it has established a customer and supplier base.