Capital Structure-Debt vs. Equity
Generally speaking, corporations raise capital through debt or equity or a combination of both. Equity investments—the purchase of shares issued by the corporation—involve the acquisition of ownership in the corporation. The equity investor becomes a shareholder, acquires property rights attendant with share ownership, is owed legal duties by the corporation, is not entitled to a return of his capital, but does participate in the profits earned by the corporation through dividends and capital appreciation. Debt, on the other hand, is a loan of money that must be repaid. Persons investing capital in a corporation through debt are creditors, not owners. Creditors acquire no property rights and are owed no legal duties other than whatever contractual duties are imposed by the loan agreement. Creditors are paid interest for the use of their money and do not participate in corporate profits, losses, or appreciation. Debt investments are commonly made through promissory notes, bonds, and debentures. As a practical matter, the neat distinction between debt and equity can break down in practice because the parties have such freedom in designing debt instruments and preferred classes of shares that hybrid securities can be created in which preferred shares have characteristics of debt or in which debt securities seem very like stock, and both preferred shares and debt instruments may be made convertible into each other.
Corporate law is based on the assumption that the capital of the company is raised through the purchase of shares of stock. However, in practice, debt is usually as or more significant. Very frequently, small corporations are set up with an agreed ownership split among the founders. The percentage split may be based on many factors—personal and emotional, as well as business. Quite often, the financial resources among the founders will be varied, and the expectation will be that one of the “partners” is contributing the idea and the work, and another is going to be the source of startup capital. In these situations, the “money partner” typically finances the corporation with shareholder loans, rather than through the purchase of shares. The advantage of this approach is to permit the founding shareholder who is providing the capital to be repaid out of the first profits generated by the venture.
Another important benefit of debt financing, when the debt comes from sources other than the shareholders—”other people’s money”—is the concept of leverage. Leverage occurs when the corporation is able to earn more on the borrowed capital than the cost of the borrowing. To take a simple example, if the shareholders invest $50,000 and make a profit of $100,000, then they have doubled their money. However, if the investors borrow half, so that they invest $25,000 and borrow $25,000, and make a profit of $100,000, then they have quadrupled their money, less the cost of interest. The trouble of course, is that leverage works both ways. If the business loses $25,000, the shareholders in the first case have lost half their investment, while the shareholders in the second corporation have lost everything.
In the event of financial difficulties, creditors have greater rights in bankruptcy and insolvency proceedings and must be paid in full before any money goes to the shareholders. However, under the so-called “Deep Rock” doctrine, courts sometimes treat shareholder debt as equity when the result might otherwise be unfair to other creditors. [See Arnold v. Phillips, 117 F.2d 497, 502–03 (5th Cir. 1941).]