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Understanding different sources of capital

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There are many different sources of capital-each with its own requirements and investment goals. They fall into two main categories: debt financing, which essentially means you borrow money and repay it with interest; and equity financing, where money is invested in your business in exchange for part ownership.

One mistake entrepreneurs often make in their search for capital is to raise too little or too much of it. They often lose credibility if it becomes clear that they have misbudgeted or misjudged actual capital needs or have failed to explore ways to obtain the resources other than buying them. The problem of misbudgeting is problematic-if you ask for too little, the cost of capital will usually be much higher and the process more painful when you go back to the well. However, if you ask for too much (even though some experts say you can never have too much capital in an early-stage enterprise) you may turn off a prospective investor. Worse, you may cause greater dilution of your ownership that was really necessary.

One way investors protect against “overinvesting” is to invest capital in stages instead of in a lump sum. These stages, or “tranches,” are often tied to specific business-plan milestones or performance objectives, such as revenues and profits, attaining customers, recruiting team members and obtaining regulatory approvals. Breaking the investment into tranches protects the investors against capital mismanagement and waste, and protects you against premature dilution or loss of capital. You may be inclined to request that all the necessary capital be invested in a lump sum (to reduce the chances that future conditions will get in the way of receiving all the money you need), but bear in mind that there may be some real advantages in being patient and allowing for a staged investment.

Andrew J. Sherman is a partner in Washington-based Dickstein Shapiro LLP, and founder of Grow Fast Grow Right, an education and training company for executives of middle market companies.

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