Here’s Everything You Need To Know About Capital Stack

Here’s Everything You Need To Know About Capital Stack

The capital stack outlines the hierarchy of diverse funding used by a project or business, shaping its financial structure.

What Is Capital Stack? 

Capital stack is a concept used in finance, particularly in the context of real estate and corporate finance, to represent the hierarchical structure of various sources of capital or funding that a project or business uses to finance its operations, investments, or development. It typically consists of different forms of capital, each with its own characteristics and priority of claim on the project’s or company’s cash flows and assets.

In a traditional capital stack, the different layers or “stacks” are organised in a hierarchy, with the most secure or senior forms of capital at the top and the riskier or junior forms at the bottom. The common components of a capital stack include:

  • Equity: This represents ownership in the project or company and is the riskiest form of capital. Equity investors, such as shareholders, have the potential for the highest returns but also bear the most risk as they are the last in line for repayment if the project faces financial distress or liquidation.
  • Debt: Debt capital includes loans, bonds, or other forms of borrowed funds. Debt investors, including lenders and bondholders, have a priority claim on the company’s assets and cash flows for interest payments and repayment of principal. Senior debt is higher in the hierarchy than mezzanine or subordinated debt.
  • Mezzanine Debt: Mezzanine financing is a hybrid form of capital that combines debt and equity features. Mezzanine lenders often have a lower priority for repayment than senior debt but a higher claim than equity investors.
  • Preferred Equity: It includes preferred equity, which is a type of equity that has preferential rights over common equity but ranks below senior debt in terms of repayment priority.

What Is Capital Stack In Corporate Finance?

In corporate finance, the capital stack refers to the hierarchy of different sources of funding a company utilises to operate, grow, or finance specific projects. This structure typically consists of various forms of capital such as equity, debt, and sometimes hybrid instruments like preferred stock or convertible debt.

Why Is Capital Stack Important?

It is essential in corporate finance because it determines the order of priority for repayment in case of financial distress or liquidation. It plays a significant role in assessing the financial risk and returns for investors and creditors. Understanding it is crucial for both businesses and investors to make informed decisions regarding financing, investment, and risk management.

What Does It Mean To Be Higher In The Capital Stack?

Being “higher” in the capital stack means having a more secure position with a higher claim on the company’s assets and cash flows in the event of financial distress or liquidation. 

In the capital stack hierarchy, Equity holders are at the lowest level and are the last to receive any remaining assets after all debts and obligations have been paid. Mezzanine debt or preferred stockholders occupy an intermediate position. Senior debt holders are at the top of the capital stack, enjoying priority in repayment.

What Is The Most Secure Form Of Capital Stack?

It consists of capital that has the highest priority for repayment and the lowest risk. In the traditional capital stack hierarchy, senior debt is typically the most secure capital because it is the first to be repaid in the event of financial distress or liquidation. This capital has a legal claim to the company’s assets before other forms of capital, providing a relatively high level of security for lenders.