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16 March 2017

The three capital blocks – equity, senior debt and asset backed finance


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The three capital blocks – equity, senior debt and asset backed finance

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Most businesses have three main sources of capital, which all play a particular role. It’s important for companies to understand how each component of the capital structure works, so they can be optimised for the organisation’s benefit.

Equity

The most valuable part of the capital structure is equity, which is the money the shareholders invest in the company. It’s the most valuable part of the structure as it is the shareholders’ accumulated value in the entity.

Let’s look at a hypothetical tech start-up as an example. In the early days the founder sells a portion of the company to raise funds, at a time when the business isn’t earning anything. Assume the business raises $1 million, and is valued at $10 million. The founder effectively gives up a 10 per cent share of the business.

Fast forward 10 years and the company is worth $100 million and is listed on the stock exchange. So that initial $1 million is now worth $10 million. This shows that selling equity can be a good way to raise funds when a business is revenue-negative, but it’s also very expensive.

Senior Debt

At the other end of the capital structure is senior debt. Senior debt is like a mortgage on a house. But instead of the lender having rights over the property if the owner is unable to make mortgage repayments, the lender has rights over the business, its plant and equipment, receivables and inventory.

Asset Backed Finance

This middle tranche of the capital structure, which sits between equity and senior debt, is asset-backed finance. By using this tranche, businesses don’t have to extend their senior debt, sell equity or put personal property such as directors’ residences at risk to grow the business. Instead, this arrangement gives lenders rights to the underlying collateral to which the lease relates.

The leasing company purchases the asset, which gives it clear title under the lease agreement. In the event the lessor can’t repay the lease the lender can sell the asset on the open market, and has the ability to value the asset given there is a discoverable market for it.

This is generally the way assets such as buses, cars, earth moving equipment, IT equipment, planes and trains have been financed.  But this part of the capital structure is predicated on the asset’s ability to produce income.

Nevertheless, this type of finance doesn’t solve the problem for businesses that need to finance an asset that is necessary for the business to grow, but that has no secondary rental value; that is, it’s worth little if it is sold. There’s another option for businesses in this situation.

Let’s say a business produces a special type of container for supermarkets. This container accommodates fresh produce boxes that can be transferred straight from the container to the supermarket shelf. The production machinery is highly specialised and has a limited secondary market value. In this situation asset-backed financing is difficult.

In this situation the best option is to choose a financing firm that looks at the intrinsic value of the asset and its importance to the business to meet its contractual obligations.

Finance firms which provide alternative capital solutions will review the importance of the assets to a business and take an equity position. This enables them to offer 100 per cent finance for assets, which in turn allows clients to become more profitable and to pursue growth opportunities they otherwise would have to pass up or for which they would need to raise equity.

Every business must make effective use of the three components of the capital structure. Only by doing this, can businesses grow and become successful.

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