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A Deal Lawyer’s Guide To Calibrating The Capital Stack

PJ Harris and Jacob Mitchell

A Deal Lawyer’s Guide To Calibrating The Capital Stack

Value Creation and the Cost of Capital

The goal of every business transaction is, or should be, to create value.  For dealmakers, value in a transaction can be defined as the generation of a return on capital that exceeds the cost of such capital.  In the context of Mergers and Acquisitions (“M&A”) and private equity (“PE”) deals, there are many discrete strategies for creating value.  Examples include increasing a company’s multiple on earnings via “add-on” investments, diversifying revenue streams to grow EBITDA (i.e., earnings before interest, taxes, depreciation, and amortization) and decreasing general market risks.  No matter how value creation is defined or pursued in a transaction, a desirable outcome for any dealmaker should be to generate a higher return on invested capital than the cost of such capital.  Deal lawyers can add considerable value for clients working toward this goal by helping them think through the best way to structure their capital stack in a given transaction.

Often, deal lawyers are asked to advise on the best way for a client to receive or inject capital into a company, such that the client both realizes greater value and does not take on undue risk.  When considering the intersection between value creation and risk, a good place for deal makers and lawyers to start is to examine (i) the different forms of financing available in a transaction, and (ii) the major features, advantages and disadvantages of each.

The capital stack, or capital structure, is the mix of capital sources an investment vehicle or venture can use to fund a business.  Different capital sources have different risk/reward profiles.  This article examines three primary categories of capital: debt, equity and mezzanine (i.e., a financing instrument with both debt and equity features).  What follows is a high-level examination of each financing option, and considerations regarding both value creation and risk avoidance for deal lawyers to be aware of when advising clients.

a) Debt Financing Considerations

The fundamental function of debt financing is for a borrower to accept capital from a lender, in exchange for a promise from the borrower to repay the debt over the course of a term (usually with interest).  Debt typically has the lowest financial risk profile of the categories buckets of capital.  Pure debt instruments are typically loan agreements that can offer borrowers financial products such as working capital, cash-flow based lending, trade financing, leasing, and asset-based lending.  The lender provides the capital upfront, and the borrower pays back the loan principal over time with interest.  If the business fails, debt investors have the first priority on the business’s assets in liquidation or bankruptcy, thus the relatively low risk profile of debt financing.

Deal lawyers can help their clients negotiate the key features of a debt instrument, including: (i) the term of the debt and the frequency of payments, (ii) the interest rate (and whether it will be accruing or non-accruing), and (iii) whether the debt will be secured or unsecured.

Secured debt includes a pledge of collateral from the borrower, such that if the borrower defaults, the lender can take ownership of the collateral in place of the defaulted debt obligation.  Unsecured debt does not include collateral, but usually involves some analysis of the borrower’s creditworthiness by the lender to give the lender comfort that the borrower has the ability to repay the loan.

Importantly, these are only a few examples of common features a deal lawyer must help clients negotiate in debt financing; there are myriad features that must be considered in every debt instrument.

b) Equity Financing Considerations

The fundamental function of equity financing is for an investor, in exchange for capital, to receive a set of ownership rights in a business that usually include at least (i) an ownership stake and attendant liquidity, and (ii) a right to transfer that ownership stake to another party (often on the public or private markets, but sometimes restricted to transfer back to the company and/or its other owners).  Equity financing tends to have greater exposure to both the downside and upside potential of the three categories of capital.  Pure equity instruments are typically agreements between a business and a member/shareholder via which the member/shareholder purchases or subscribes to common shares in the venture and participates pro rata in the venture’s profits over time.  If the business fails, common shareholders may lose their entire investment, but if it succeeds, they get to participate in the company’s growth and profitability.

In addition to ownership rights and transfer rights, some additional examples of key features of an equity investment that deal lawyers can help negotiate include: (i) voting rights, (ii) information rights (i.e., the right to access and inspect corporate records), and (iii) liquidation preferences (i.e., a contractual predetermination of the payout order in the event of a liquidation of the company).  As with debt financing, these are only a few examples; there are myriad features that must be considered in every equity instrument to negotiate an appropriate risk profile for clients.

c) Mezzanine Financing Considerations

Between pure debt and pure equity financial products exists a broad and disparate category, often referred to as “mezzanine finance.”  Mezzanine products can be thought of as a hybrid between debt and equity and are often associated with acquisitions and buyouts.  Mezzanine can be an optimal approach for crafting an innovative and nimble capital stack depending on a company’s needs and an investor’s desires, shaped for a specific venture or fund.  Below are a few high-level summaries of some mezzanine financial products:

Subordinated Debt: Subordinated debt typically takes the form of an unsecured loan that, though it still usually takes priority of repayment in a bankruptcy event over equity holders entitlements, falls below more senior loans or securities with respect to its claim on assets and earnings.  Subordinated debt is debt-like in that it is structured as a loan, but it also has equity-like features because the debtholder participates in some of the venture’s risk by lending unsecured capital.

Convertible Notes: A convertible note starts out as a fixed-income debt security that yields interest payments but can be converted into equity shares of the venture based on a pre-determined conversion rate and triggering event, which is typically heavily negotiated as part of the transaction.  A convertible notes conversion from debt to equity places it solidly in the mezzanine category.

Preferred Stock: Preferred stocks are technically equity interests, but they have debt-like features in that they convey a senior claim to the venture’s assets and earnings as compared to common stock shareholders.  Because preferred stockholders have a priority interest in the company’s assets, earnings, and/or distributions relative to common stockholders, they typically have limited voting and governance rights.

Investor Risk Profiles: Deal lawyers must recognize why different investors prefer one type of financing to another in a transaction.

In comparing debt to equity, for example, a pure debt investor will only ever be entitled to receive the return of its initial investment plus interest, while an equity investor expects to participate in the gains on the upside through its investment.  Debt has the benefit of self-liquidation and cost, since it can be cheaper in the long-term for a value-creating venture, but equity has the benefit of accompaniment, flexibility, and patience.  Investors who prefer debt might be more risk adverse, while investors who prefer equity may be willing to take on more risk for potentially greater returns.  Meanwhile, investors interested in mezzanine products may fall somewhere in between these deal motivations and instead want to pursue a hybrid financial product that can be tailored to meet that investor’s specific needs in the transaction.


As we have explored, there are many considerations a fund, venture, investor or founder must contemplate when strategizing how best to structure and participate in the capital stack of a business.  In the event of a liquidation, debt, equity and mezzanine are treated differently in terms of when and how much of the liquidation proceeds a lender, investor, or owner receives.  In some cases, there may not be enough proceeds to remunerate all claimants, and in others, the returns may be so great that compensation is not a question of “if” but “when.”  In every case, though, the terms negotiated in the financing documents are the terms that will guide the liquidation process.  It is therefore important for deal lawyers to be involved from the very beginning of the financing process and recommend and advise on the best option(s) based on their clients’ desires and risk tolerances.

Because different categories of capital come with different costs and benefits, it is critical for deal lawyers to help clients consider which form of capital is right for them in a given context or, more particularly, what combination may be optimal over a company’s or venture’s life cycle.  A deal lawyer must not only understand the mechanics of the financing instrument through which the capital will change hands but should also be able to advise clients on the associated risk tradeoffs between the options.

The optimal calibration of the capital stack makes value creation in M&A and PE more achievable.