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It’s Part 2 of our 5-part series on designing a capital structure. Last week, we explored the capital lifecycle and some of the key features of capital (beyond just quantum and cost).

In short, a “30,000-foot view” of capital structure and strategy.

This week, we’ll go even deeper and break down how capital structure design meets your FP&A function. We’ll start with the theory and work towards a practical example in the final week of this series.

Note: We’re not talking cost of capital yet. That comes later. First, we need to understand what capital the business deserves, not what it’s priced at.

Introducing Capital Features

Your strategy determines your operating model. And your operating model has certain attributes that define the type of capital your business needs.

Let’s call them ‘Capital Features’:

Let’s get into the different Capital Features and the impact they have:

1) Revenue Predictability

Is revenue recurring, project-based, or seasonal? 

What percentage of revenue is retained vs churning? 

Is there a natural trajectory of revenue, i.e., growth or decline? Fast or slow? 

How concentrated is your customer base? A revenue stream dominated by a few large customers, no matter how recurring, still brings risk.

The more predictable and diversified revenue is, the more ‘debt-friendly’ the business becomes. The more volatile it is, the less suited the business is to fixed monthly or quarterly payments and covenants.

This is why Private Equity likes mature businesses. Competitive dynamics have played out, and a natural market order is established. Even in non-growth markets, competitive equilibrium keeps revenue inside certain tramlines, at least in the short term.

This makes it easier to load up on debt and make small slivers of equity work extremely hard.

2) Cash Conversion Cycle (CCC)

Is the cycle fast (SaaS), slow (construction), or negative (retail)?

The CCC tells you how easy it is to fund growth and how resilient the business is in a downturn.

A construction business with a long CCC will need significant capital to grow. We saw last week how Carillion tried to match a lengthening CCC with extended supplier terms. Their CCC was too volatile, long, and complex to fix with supplier credit alone (which is rarely sustainable anyway). It needed a more structural fix.

Retail businesses often enjoy self-funding growth thanks to a negative CCC. But god help you if sales fall into decline…

The CCC determines how cashflow behaves as the business grows or declines. And your capital structure must complement it.

3) Working Capital Mix

Does the business sell atoms (physical products), bits (digital products), or people (services)? 

And if it’s inventory-led, do you make product or move it?

Physical product businesses have more complex (and riskier) CCCs than those that don’t. Especially if they manufacture, rather than just distribute.

In manufacturing, the layers of inventory (raw materials, WIP, finished goods) introduce additional risk of volatility in CCC. Plus inventory is harder to fund with debt than receivables. So the composition of your working capital matters.

4) Working Capital Seasonality

Is there a seasonal dynamic to working capital?

Seasonal working capital, especially tied to seasonal revenue, is hard to manage. Spare a thought for fireworks manufacturers. They run factories all year to manufacture fireworks, but only have demand around two or three key holidays.

Their CCC builds each month, growing by 30 days at a time, before crashing back to near zero ahead of July 4th or New Year’s. Just in time to start the cycle again.

If you’ve worked in a highly seasonal business (I have), your working capital funding strategy is 90% of your business strategy.

5) Gross Margin Profile

How high and how stable are your gross margins? And how sensitive are they to FX or input prices?

Higher gross margins give more room for error and more headroom for future profit expansion.

The best gross margins for raising capital are disgustingly high. But if that’s not an option, the next best thing is rock-solid stability.

Costco and commodities giant Cargill each operate with gross margins barely over 10%. But they are fundable because those margins are stable and backed by scale, process, and discipline.

6) Asset Intensity

How big is the capital asset base of the business?

The value, quality, and portability of a business’s asset base are crucial in assessing its ability to raise debt.

Banks prefer hard assets. Things they can touch. Or take.

That’s why early-stage tech businesses are often unbankable. What’s a bank going to do if you don’t pay… kidnap your software engineers?

That said, many businesses today raise debt on a cashflow basis. But even those lenders often still want the comfort of some asset coverage.

This is where venture capital changed the game.

Nothing illustrates this better than Shoe Dog by Phil Knight (the story of Nike). He spent years on the brink of financial ruin, unable to find a bank to fund his working capital. Until he discovered the marvel of Japanese trading companies. The rest is history. Today’s he’d have a buffet of debt and equity solutions to chose from.

7) Burn to Grow?

Will you need to burn cash to grow? Typically, that means up front product development and customer acquisition costs (CAC).

In tech startups, it’s accepted that you’ll need to invest in engineers and CAC before you see results. But the revenue you generate is usually high-margin and high-quality. That’s perfect for equity funding, but the uncertain payback period and lack of cashflow does not suit debt.

This is what makes Direct-to-Consumer (DTC) eCommerce so hard to fund. They have a J-curve cashflow profile due to upfront CAC. But they often lack the long-term upside of tech or the stability of physical asset bases. The whole funding category of Merchant Cash Advances (MCAs) evolved to solve this problem. More on that in week 5 of this series.

This is probably the most material capital feature of all. By definition, burning cash to grow is an equity story. Usually VC.

Your mix of Capital Features

It’s the combination of capital features that determines your target capital mix. Note the word: target. You may not be able to get what you want.

In that case, you either adapt your strategy or operating model to fit the capital you can access. Or you try to force a round peg into a square hole.

That can work too, as long as the mismatch is small, acknowledged, and there’s a credible plan to close it. Either by growing into new capital options, or by refining your business model to match what's available.

Let’s talk about a time when that gap DIDN’T resolved… (until the market solved it for them):

You don’t always get punished for a bad capital match, at least not immediately. Sometimes, if the narrative is strong enough, you get rewarded for it.

That’s what happened with Allbirds:

At its peak, this wasn’t a shoe business. It was a tech-flavored ESG story wearing wool sneakers. And the capital markets lapped it up.

By 2020, Allbirds had raised over $200 million across multiple rounds. Its Series E gave it a $1.7 billion valuation. Then came the IPO in 2021. Valued at $4 billion.

Revenue for that year would finish at $277 million, a valuation multiple of nearly 15x sales. Meanwhile, it posted a $45 million GAAP net loss. For comparison, Nike trades at around 3x sales and does so with an operating margin of around +10%. And that’s Nike…

Today, Allbirds’ market cap is less than $100m. The market quickly figured out what they were: an unprofitable sub-scale shoe company:

But for a while … it was Silicon Valley-approved, and retail investors were left holding the bag.

Let’s test it against the Capital Features:

This wasn’t a company designed to carry that level of capital, and had no right to the kind of equity capital reserved for tech businesses.

But a brand story, some VC gloss, and the ESG halo helped it defy gravity and shoehorn it into the ‘burn to grow’ box.

It was always a shoe business, not a tech company.

Great CFOs raise capital based on what the operating model needs, not whatever the market will let them get away with. And the discipline that comes with the right capital, helps keep them on track.

Which brings us to the real work: modeling what the business actually needs, before you even begin thinking about who or what might fund it.

Capital Requirement Profile

Before you pick your funding, you need to know what you’re funding; the Capital Requirement Profile.

That means stripping away the constraints of what capital is available, and modeling what the business would do if capital weren’t a constraint.

To get to the Capital Requirement Profile, you need the cleanest version of your business plan, before capital starts distorting it.

In practice, this means getting to a set of scenarios for the operating business, typically from revenue down to operating profit, and then reconciled to operating cashflow.

I call this the Unfunded Model i.e., a financial model that hasn’t (yet) solved for financing.

It’s a job that sounds PERFECT for FP&A…

The Role of FP&A in Funding

The best financing exercises have an FP&A team working in lockstep with a treasury/IR team. FP&A owns the Unfunded Model and the treasury team then owns the funding solution. Specifically, they own the modeling ‘beneath’ operating cashflow.

This should be a dynamic relationship, as there is intense circularity between operating cashflows and the financing strategy. Anyone that’s ever modeled new debt into a 3 statement model will tell you it doesn’t take long before you see this:

Even if you are working in a smaller team, and you have one person doing the whole thing, it is worth separating the roles in your mind. One half is business-facing, generating the demand for capital, and the other half is solving for the supply of capital.

But the magic will happen when they come together, resolving the circularity between the strategic options in the business and the funding solutions available.

For the rest of this piece, we will focus on calculating the ‘demand’ side: the Capital Requirement Profile.

Building an Unfunded Model in Practice

The process of building an unfunded model looks very similar to a long-range planning process. In fact, you can often plug it directly into your annual LRP, or run a one-off LRP.

By following the best practices for an LRP process (seriously, go read my piece), you can ensure the business, its strategy, the exec, finance team, and board are all working in lock step.

Modeling Uncertainty

We can think of building up the Capital Requirements Profile in several layers.

First, there is a base plan.

Start with the core trajectory of the current business. No bells, no whistles. Just the status quo, scaled forward. This tells you the baseline capital requirement. How much funding does it take just to stay on track?

Next up, there are upside and downside cases. These show what happens if things go better or worse than expected. Think here about execution risk, not strategic options:

The key output here is understanding how much flexibility your capital structure needs to absorb shocks or capture tailwinds. And remember: flexibility costs money.

Next up, there are investment overlays. These are your optional plays. The things you’d like to do, if you could fund them. The strategic stuff:

The job here is to scope what those options would cost and what return they might deliver. This layer is where your “unfunded wish list” starts to come to life.

Once you have built this up, you can define your menu of scenarios. Each scenario will be some combo of 1 (base), 2 (volatility), and 3 (optional growth). For each one, you need a view on:

Here’s a simple example with visualization for a tech start-up:

Here, you have a base capital requirement represented by the pink line. Growing over time (it’s cumulative) with no immediate prospect of it becoming cash generative.

Then there is an upside & downside case against that. Maybe CAC is lower than we planned (upside), reducing the capital requirement (blue dotted line).

Or maybe it takes more engineers than we hoped to build the product (purple line). The sensible thing for the cautious CFO would be to build some cushion into the funding requirement and fund to the purple line.

But there is also the option to accelerate growth. Investing more in customer acquisition. And that option could be triggered at any time through a future funding round. A simple example of an option available to management (subject to funding).

Now let’s look at a more complex profile:

This is a mature business. Let’s assume it’s a PE-backed manufacturing business.

Firstly, there is an inherited level of capital. If this is funded by patient equity, then it’s not relevant. But if it’s funded by debt that needs refinancing, or an owner that is looking to exit, then a capital requirement profile would need to consider this.

Then, on top of that, there would be a profile of new capital required to fund further operating cashflow outflows. The base plan here is in pink. At first, it’s a cash outflow, then it starts to pay back, and by the end of the plan even eats through the inherited capital requirement.

Then, against that, there is an upside scenario (the payback happens faster than expected) and a downside cushion (the payback never materializes).

Finally, if the business plans a major capex project later in the plan, that could be another specific capital requirement.

This starts to illustrate the complex web of options available to the CFO. Depending on business performance and strategic options selected, the shape of the capital requirement is radically different. And this only gets more complex as you layer additional strategic options in.

So, how do you ensure you have all the capital you need, without risking sitting on expensive surplus capital? (Remember, flexible capital is expensive.)

One way to mitigate this is to build conditional triggers for making an investment in the business.

I remember years ago, we had a major strategic investment on the table. The biggest the business had ever considered. The exec team kept asking: “When can we go?” They were looking for a date.

But I was clear, time wasn’t the trigger. It was operational. There was a set of conditions we needed in the business to afford it:

I knew if we hit those triggers, we would have no issue attracting the funding we needed. That meant I could avoid building that capital requirement before it was necessary, but also ensure that the capital would be there, when we were ready.

Once you've built your unfunded model (base case, scenarios, and investment overlays), you’ll have the only thing that matters: a clear view of the capital your business actually needs.

And by considering what optionality you need in your plan, you can define the true demand for capital in your business.

Next week, we start on the ’supply’ side of capital, beginning with debt: what it can do, what it can’t, and how to pick the right debt.

And don’t worry… we’ll bring this all together with a worked example in the final week.

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Disclaimer: I am not your accountant, tax advisor, lawyer, CFO, director, or friend. Well, maybe I’m your friend, but I am not any of those other things. Everything I publish represents my opinions only, not advice. Running the finances for a company is serious business, and you should take the proper advice you need.