Most startups are financed by their founders. However, as your business grows, more funding options become available. These usually involve some type of debt or equity instrument and, collectively, all of the money invested in your business makes up your capital stack.
Few entrepreneurs pay much attention to their capital stack. They're usually more concerned with how much capital they can raise than how it gets structured. However, managing your capital stack is a very important executive responsibility because debt and equity involve very different costs and covenants.
For example, debt is usually less expensive than equity because creditors have first claim on a company's assets. However, loan repayments are often fixed and immediate, whereas equity-related cash outflows tend to be variable and discretionary.
Striking the right balance between debt and equity becomes increasingly important as your business scales because you can't rely on just one of them indefinitely. You'll end up with both sooner or later, but their proportional contribution to your capital stack will affect your weighted average cost of capital (WACC).
For example, a company that raises half of its capital through debt at a cost of 10% and the other half through equity at a cost of 20% will have a WACC of 15% (i.e. 50% x 10% plus 50% x 20%). (WACC is actually calculated using after-tax capital costs, but I've excluded tax to keep this example simple).
So why does WACC matter?
Simple: companies with a lower WACC relative to their competitors are at a huge advantage because it literally costs them less money to raise more growth capital. Imagine having to pay 15% a year for finance while a competitor cruises along at 8%. Even a marginal difference can compound significantly over time and contribute to very different long-term financial positions.
Whether you're trying to build a profitable lifestyle business or a vast commercial empire, think carefully about how the money that you invest fits together. Without a long-term perspective, you'll likely end up with a messy capital stack and an unnecessarily high average cost of capital.