Capital Structure
Capital structure is the mix of debt and equity a business uses to fund itself --- two sources of money with fundamentally different costs, risks, and control implications.
What is it?
Every business needs capital to operate. That capital comes from two sources: debt (borrowed money that must be repaid with interest --- a liability) and equity (the owners’ own money or retained profits --- equity). The ratio between them is the capital structure.1
The choice is not neutral. Debt is cheaper (interest is tax-deductible and rates are lower than equity returns) but rigid (payments are mandatory regardless of business performance). Equity is expensive (owners expect higher returns than lenders) but flexible (no mandatory payments; dividends are discretionary).
In plain terms
Debt is renting money --- you pay interest for use and return the principal. Equity is owning money --- no repayment obligation, but the money’s owners want a share of everything you build.
How does it work?
The trade-off
| Debt | Equity | |
|---|---|---|
| Cost | Lower (interest, tax-deductible) | Higher (owner expects returns > debt rate) |
| Obligation | Mandatory payments | No mandatory payments |
| Risk | Default if payments missed | No default risk |
| Control | Lenders have no operational control | Equity holders may have governance rights |
| Upside sharing | Lenders get interest only | Equity holders share all upside |
A business funded 100% by equity is safe (no debt obligations) but expensive (all capital costs the high equity rate). A business funded heavily by debt is efficient (cheap capital, tax advantages) but fragile (mandatory payments can trigger bankruptcy during downturns).
Leverage effect
Debt amplifies returns in both directions. If a business earns 15% on its assets and pays 5% on its debt, the owners capture the 10% spread. More debt = more spread captured = higher return on equity. But if the business earns only 3% on assets while paying 5% on debt, the spread turns negative and equity erodes.
This is why leverage is a Layer 6 concept --- it applies broadly beyond capital structure to any use of borrowed resources.
For early-stage ventures
Startups and early ventures typically cannot access much debt (no assets to collateralise, no track record). They are funded primarily by equity --- the founder’s own money, then angel investors, then venture capital. Each funding round dilutes the founder’s ownership percentage.
For a solo entrepreneur or small business, the capital structure question is simpler: bootstrap (use your own savings and revenue --- 100% equity, 100% control) or borrow (take a loan --- leverage, but repayment obligation). Your entrepreneurial-runway is effectively your equity contribution to your venture.
Check your understanding
Five questions (click to expand)
- Explain why debt is cheaper than equity despite being riskier for the borrower.
- Describe the leverage effect. When does debt increase returns on equity and when does it destroy them?
- Compare bootstrapping vs raising external capital for an early-stage training business. What are the trade-offs?
- Connect capital structure to financial-statements. Where do debt and equity appear on the balance sheet?
- Evaluate this claim: “A business should always minimise debt.” When is this wrong?
Where this concept fits
Where this concept fits
graph TD EQ[Equity] --> CS2[Capital Structure] LI[Liability] --> CS2 ROI[Return on Investment] --> CS2 CS2 --> VA[Valuation] CS2 --> LV[Leverage] style CS2 fill:#4a9ede,color:#fff
Sources
Footnotes
-
Modigliani, F. & Miller, M. H. (1958). “The Cost of Capital, Corporation Finance and the Theory of Investment.” American Economic Review, 48(3), 261-297. The foundational paper on capital structure, earning both authors the Nobel Prize. ↩