Capital structure planning and optimization is a value-enhancing management tool that works hand-in-hand with strategic planning.
SWOT Analysis
Strategic planning begins with a SWOT analysis. A SWOT analysis is an evaluation of the current position, which includes Strengths, Weaknesses, Opportunities and Threats. We make plans around these factors. In some respects, your capital structure will likely be incorporated into that analysis and planning. Is it holding you back? Perhaps underutilized or over-leveraged? Which quadrant did you place your capital structure in? Where should it be?
Goal-Setting
Next, in strategic planning, we typically ask ourselves where we want to be in three, five and 10 years. As you consider your specific goals, you then consider what’s needed to meet those goals. Perhaps additional business development resources for a new territory, a capacity expansion or maybe a product line extension. Many of these needs will share common concerns, such as project funding and the ROI compared to your cost of capital. A targeted capital structure should fall out of that thinking. Be mindful that your optimal capital structure will change depending on the circumstances and your intermediate and long-term goals at any given time.
Optimal Capital Structure
But what is an optimal capital structure? It is more than simply the lowest-cost debt or maximum debt availability. The optimal capital structure balances the cost of all capital with the return on its investment. Ultimately, the goal is to fully allocate capital to projects with the highest risk-adjusted return in excess of the cost of capital available to the Company.
Capital availability is not unlimited. The use of funds, size of the Company, stability of earnings, margins and magnitude of current and additional financing all impact types of total capital available and total capital availability. A smaller business may be limited to fully secured bank debt and inside equity capital, while the larger business may also avail itself of bank financing, long-term insurance company debt, professional mezzanine debt and outside equity capital.
Debt Capacity Analysis
With these constraints in mind, I often recommend that the early stages of starting strategic planning begin with debt capacity analysis – how much capital do I have available to deploy (beyond day-to-day operating needs), and at what cost? Am I willing to accept subordinated debt or give up equity to achieve specific goals? With that knowledge, I can better consider the range of potential projects, capital needs, and, ultimately, full capital utilization. The maintenance of operating liquidity and flexibility is a must. Seasonality may also be a factor. Beyond that, value maximization depends on the full allocation of excess capital.
Company’s Risk Tolerance
Be mindful of your company’s risk tolerance, too. A long-tenured management team understands the business well and has a well-grounded feeling of how much risk it can assume. Don’t undervalue this feeling; it is based on experience. For some companies, a more straightforward capital structure of traditional bank debt and inside equity is appropriate. Others may be comfortable with various other capital instruments to support their strategic goals.
Map Your Strategy
Ensure you have the necessary human capital to support your objectives while aligning your strategy with both current and future corporate operating needs. Evaluate the availability of financial resources necessary to effectively execute your plan. Set clear performance milestones to track progress. Regularly review your strategy and its performance against expectations, making adjustments as needed, including potential modifications to your capital structure. Aim for the range between B and D in the illustration below.
Timing
Not to be overlooked is the impact of timing on your capital structure and the future impact of investments you may make. Many companies find themselves overcapitalized as they focus on reducing debt and overshoot their targets. For example, assume the Company is leveraged at 2.50x Senior Funded Debt / EBITDA (SFD/EBITDA) today and maintains a corporate target of 1.00x. Operations are sound, and in three years, that goal is met; in five years, the Company is debt-free, arguably overcapitalized, and missing value-enhancing opportunities. Considering the optimal capital structure, at the 3–5-year point, the Company in our example should be executing on an acquisition, strategic initiative or recapitalization. If, instead, this is the point that they consider “what comes next,” they will likely find themselves overcapitalized for the 18-24 months that it may take to identify and execute their strategy. Timing is crucial when optimizing the use of your available capital. It’s important not to focus solely on today’s capacity. Instead, look ahead to what your debt capacity is likely to be in the future—often increasing—and plan for its use at those future levels. Underutilized capacity of $3,000,000 today may indeed be underutilized capacity of $7,000,000 two years from now. And as a result, deploying $3,000,000 in two years may in fact result in underutilized capital availability
No two businesses are alike in terms of their optimal capital structure. In the schematics to the right, we illustrate three very different businesses.
Company A exhibits very low business risk as a dominant player in a narrow but critical market. Its cash flows are strong, consistent and predictable (supported by multiple favorable long-term contracts) and reinvestment needs are minimal. Company A’s capital structure is likely optimized with a relatively high degree of leverage.
Company B is a relatively young player in an evolving market. The concentration of customers, an increasingly competitive marketplace and lack of assets present heightened business risk at Company B and in turn an optimal capital structure that must be more fully equity capitalized and less reliant on leverage.
Most businesses are not at these extremes but instead show a balance of risk and leverage similar to Company C. In fact, Companies A and B will likely maximize value as they strive for the balance of Company C.
Company A might strategically seek to utilize its excess capital availability while Company B seeks to reduce its business risk. Company C will likely teeter-totter above its fulcrum as its value-enhancing opportunities continue to evolve. Each of these strategies have considerations related to capital structure.
Wrapping Up
In conclusion, all businesses have capital structure considerations when creating a strategic plan that maximizes value. Key capital structure components are overall capital availability, the cost of various capital components and the risk-adjusted return of available strategic alternatives. Value is maximized when capital is allocated to those projects earning the highest risk-weighted return over their cost of capital. While each of these can be measured, there is also the “gut feel” concerning what is acceptable that experienced management brings to the table. Don’t overlook this softer component, as it is often correct. Measure your debt capacity, understand your human and financial capacity now and through the future, build strategic plans with consideration to this capacity and optimize the use of your total capital to maximize shareholder value.
Richard Shuma is a Managing Director at Prairie Capital Advisors, Inc. He can be contacted at 630.413.5598 or by email at rshuma@prairiecap.com.
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