Understanding capital: the composition of all businesses

To outsiders, finance can feel like a foreign language—full of acronyms and jargon like PE, VC, M&A, and derivatives. But once you understand the basics, much of it starts to make sense. Below, I explain one of the most fundamental finance concepts: capital.

When you hear the term "capital," it refers to money a business can use to fund its growth and ongoing operations. There are two types of capital - "equity capital" and "debt capital," and businesses are financed through a combination of both.

With equity, investors provide funds to a business in exchange for an ownership stake, which entitles them to a share of future cash flows. In contrast, debt investment involves providing funds without gaining ownership; instead, investors receive periodic interest payments. Debt holders are also prioritized in a company's capital structure, meaning they are paid first in the event of bankruptcy, reducing their risk compared to equity investors.

Equity Capital

Equity capital, or equity, is the primary source of capital for small, early-stage companies. Founders usually prefer not to invest all their personal savings into their business, so they seek equity funding from family, friends, and "angel investors" or "seed investors," who specialize in offering equity investments to early-stage entrepreneurs. Typically, these early-stage investors provide equity to a company in exchange for 10-30% ownership.

As a business grows, its capital needs increase, often leading it to seek larger injections of equity from venture capital (VC) firms. After angel and seed investors, VC firms are the next major provider of equity in a business's lifecycle. Numerous VC firms, both small and large, exist in the market. Notable examples include Sequoia Capital, Khosla Ventures, and Kleiner Perkins. VC firms raise their funds from high-net-worth individuals and institutional investors, such as insurance companies and pension funds. In a study of 105 technology companies that went public, VC firms owned, on average, 50% of a company at the time of IPO.

Once a business achieves a significant scale and generates enough cash to support its operations, it no longer requires large amounts of equity. However, the company's owners (shareholders) might wish to sell part or all of their ownership to finance personal life events, such as purchasing a house or making another investment. To accomplish this, they generally consider two main options: "going public" or selling to private equity.

"Going public" refers to a company undergoing the initial public offering ("IPO") process. This option is generally ideal for owners and businesses that wish to sell a portion, but not necessarily all, of their ownership in a company. It also serves as a way to provide liquidity to early employees who received equity in the company as a form of compensation, as well as early investors (e.g., angel investors, VC firms) who wish to cash out some or all of their position.

The second option—selling to private equity ("PE")—is more common for small and medium-sized businesses. In this scenario, a private equity firm buys all or a significant portion of a business, using a mix of equity (from funds raised from investors) and debt. This enables business owners to cash out their stakes. Some of the largest and most renowned PE firms include Blackstone, Apollo Global Management, and KKR.

An important point worth calling out is that "private equity" technically encompasses venture capital, since both venture capital and private equity firms raise money from investors to supply equity to private, non-publicly traded companies. Businesses listed on a public exchange are deemed "public" (such as Apple, Amazon, Microsoft), while all other businesses are classified as "private" (like your neighborhood Thai restaurant, a laundromat, a plumbing company, or even some large companies like OpenAI and Stripe).

Interestingly, the share of publicly traded companies has declined considerably over the past 25 years. In 2000, there were about 6,000 publicly traded companies in the US. By 2020, this figure was 4,000. Over this same period, private equity assets under management (AUM) have grown from $1T in 2000 to approximately $5T in 2020, suggesting that the growth of private equity has created fewer investment opportunities for public market investors over the last two decades.

Debt Capital

The second method of financing a business is through debt capital, or debt. Debt is typically reserved for businesses that possess a foundation of assets and established cash flows. This is because debt investors generally want to take on less risk in exchange for a lower rate of return on capital. Debt investors achieve reduced risk by:

1. Ensuring the businesses they lend debt to have assets and cash flows that can be collected upon to ensure the required periodic interest payments are made.

2. Occupying a higher position in the business's capital structure. This means that if the company becomes bankrupt (i.e., runs out of cash), debt holders are the first to be paid from the business's proceeds, minimizing the risk of permanent capital loss.

Many people believe businesses obtain most of their debt from banks, which is correct. Approximately 40% of business debt originates from traditional bank loans. The funds that banks lend come from the balances in individuals' bank accounts. Banks lend out money deposited by their customers—paying savers a small interest rate (say, 3%) and charging borrowers a higher rate (say, 7-9%). The bank profits from this spread.

The second source of debt originates from bonds, accounting for approximately 35% of business debt. Bonds are securities that companies issue, and businesses appreciate this financing method because it allows them to raise capital without sacrificing equity (ownership). Investors like this asset class because it is considered low-risk, again thanks to its priority position in a company's capital structure.

The third, and increasingly growing, source of debt capital is private credit, which functions similarly to PE and VC funds. Investors contribute money to a private credit firm's fund, which is then used to provide debt to businesses. Private credit firms typically lend to businesses in high-risk scenarios where traditional banks and bondholders are reluctant to offer capital. Today, private credit accounts for about 25% of business debt. Because of the high-risk nature of private credit lending, the returns are generally higher than those from bank loans and bonds. As always, risk is paired with return.

Conclusion

Capital—whether it's equity or debt—is the composition of every company. By understanding the different types and use cases of capital, we are now equipped to dive into more advanced financial concepts.

Sources:

1. Federal Reserve: https://www.federalreserve.gov/econres/notes/feds-notes/private-credit-growth-and-monetary-policy-transmission-20240802.html

2. Nasdaq: https://www.nasdaq.com/articles/the-growth-of-capital-in-private-investment-offerings

3. Crunchbase: https://about.crunchbase.com/blog/venture-capitalist-percentage-ownership/?utm_source=chatgpt.com

4. McKinsey: https://www.mckinsey.com/capabilities/strategy-and-corporate-finance/our-insights/reports-of-corporates-demise-have-been-greatly-exaggerated

5. Individual analysis