The fundamental principle in modern theories of the firm (i.e., the legal and financial notion of the modern corporation) is the capital structure. If a company can best be thought of as a combination of different people using specialized skills together to produce a good or service, the capital structure is how that company gets the funds needed to keep those people at work and the firm operating/expanding. Famously, the capital structure is best conceived as a pyramid with three main sections:
At the top are senior debts–these are debts that have a lien attached to them, meaning that there is a specific company-owned asset collateralizing the debt. Underneath that is subordinated debt, which is connected to the company’s broader capital flows–you can think of the firm itself as collateral for that debt. And then there is equity–an ownership stake in the firm that provides investors with a share of net earnings after debt obligations are paid.
In modern financial terms, senior loans are the most well-known senior debt, while corporate bonds are subordinated debt, and preferred and common stock are types of equity with different levels of rights attached to them. What a good financier will do is understand which type of capital is right for what type of investment and situation. Thus a high risk growth fund may take on equity in a fast growing company, whereas a low risk growth fund may give debt to a fast growing company. Both are focused on growth, but they use the capital structure to target the kind of risk they want to take on.
As a tool of asset exposure and risk, the capital structure is important for investors. But how is the capital structure used on the corporate side? When a company needs to raise money, the capital structure is an important consideration for what kind of trade off they want to make in order to access capital. Senior loans will typically have lower interest rates but put a company’s assets at risk. Issuing new shares will dilute current ownership, but the value of those shares can go to zero. Thus when Hertz (HTZ) recently looked to get itself out of bankruptcy, they looked to issue shares even though they knew (and disclosed) those shares would almost certainly go to zero. But if a market was willing to buy a billion dollars worth of shares that were likely to go to zero, HTZ would be smart to take advantage of that inefficiency. Financiers function in dual roles when it comes to the capital structure. Investment bankers will advise corporate clients on what kind of fundraising they should do (take out a loan, issue a bond, issue new shares), while buyside analysts will analyze what kind of capital offerings (senior loans, corporate bonds, stock) have the best risk/reward profile and fit the mandate of their investors. A crucial understanding of the benefits of each kind of capital is necessary for the smooth functioning of capital markets and a successful fund raising for companies.