The Difference between Smart Capital and Simple Capital
We can all agree that $1 million is a lot of money. You can do a lot with that kind of money, but for an entrepreneur seeking growth capital, there can be critical differences in where that money comes from and what strings are attached. Most investment capital requires some share of equity in the ownership and control of the firm. At face value, a higher equity stake would seem to be a worse deal. The other side of that equation is what the company will be worth when the time comes to settle up. If one investor requires a 10 percent stake but can help grow the firm to $50 million in value, that can be a better deal than an investor that wants only 5 percent but can only help the company grow to $20 million. In the first case, you owe them $5 million for their $1 million, but there is $45 million of equity left. In the second case, you only owe $1 million, but provided no return to the investor, and there is less equity left to grow the company.
You can’t always know which investor can help you grow to $20 or $50 million, but a big factor can be where that money comes from. If it is an investor that understands the hot new emerging industry from experience, innate savvy, or deep research, it is more likely to help that entrepreneur grow regardless of the equity stake given up. An investment from a knowledgeable source brings not just money to the table but strategic advice, and even more importantly, those investors bring access to their networks of experts and talent. Those assets magnify the value of the $1 million. Let’s call that smart capital.
An investor that doesn’t understand the hot new emerging industry is less likely to have the right network and less likely to provide good strategic advice. For sake of simplicity, let’s call this simple capital.
My role is not as an investment advisor for entrepreneurs but as an advisor to communities and regions trying to innovate. I framed this cautionary tale from the perspective of the entrepreneur to make clear the real risks and returns faced by entrepreneurs and the communities they call home. Many entrepreneurs starting out will take whatever capital they can get. And many regions seeking to grow through innovation and entrepreneurship will seek to provide more access to capital by creating local funds from wealthy investors who don’t understand the markets they are investing in.
The lesson here is not that you shouldn’t raise local funds. The lesson is that you need to understand the limits of what capital alone brings to the table. Raising the investment fund or building a network of angel investors is only half the battle. You also have to educate them about what they are investing in. If you can then use that simple capital to build a large-enough pool of deals in your community, then you can attract smart capital to de-risk your deals for both sides. Many communities fear that smart capital will take the best prospects out of the community, but that risk should not prevent entrepreneurs or communities from seeking the smart capital that will help them grow.
For entrepreneurs and for communities, the biggest risk is never trying at all, but if you’re gonna try, be smart about it.
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