Venture Capital Vs. Private Equity
Posted: Feb 8, 2023 1:49 PM ET
While seeking external funding for a business, private equity and venture capital appear to be similar but they have noteworthy distinctions. Although both invest in privately owned companies for a share of ownership, their investment strategies vary greatly. In this article, we’ll take a look at what makes them different, the pros and cons of each type of funding, as well as how they create value for companies.
What is Venture Capital?
Venture capital is classified as a form of private equity, with the key distinction being that private equity investors generally gravitate towards well-established companies, while VC investors typically enter in during the startup stage.
Venture capital is commonly given to small companies that have high growth potential. However, it is not readily available and often involves more risk. The reason VC investors participate is because of the possibility of significant returns.
How does a venture capital firm bring value?
A venture capitalist plays an active role in supporting upcoming companies beyond being a passive financial backer. Venture capital partners are responsible for monitoring their investments through numerous board meetings. As a result, their expertise becomes a valuable asset for companies to utilize.
Venture capitalists can be influential in sales and fundraising for startups once they have a stake in the business. Additionally, their network of connections to skilled senior talent can assist with launching new ventures.
Pros and cons of venture capital
Venture capital funding provides valuable assistance to new companies during their initial stages of growth, similarly to private equity investors who bring their knowledge and expertise.
Minimizing risks and avoiding common mistakes in the early stages of a startup can be helped by working with an experienced team, as new businesses have a higher rate of failure. Additionally, VC investors often have strong connections and can assist in finding new opportunities.
However, when you raise a funding round, you dilute your equity and issue shares to your investors. And if you need to raise additional rounds, you’ll reduce your ownership and control over the company even further.
What is Private Equity?
Private equity refers to a form of investment wherein a group of investors directly invests in a private company. Normally, private equity investors concentrate on mature companies that have already passed the growth phase. They frequently offer financial support to businesses that are experiencing difficulties.
Private equity investors may acquire a business, enhance its performance, and eventually divest for a gain. Their sole objective is to augment the company’s value and yield profits from their investment.
How does a private equity firm bring value?
Private equity firms usually purchase businesses that are experiencing financial difficulties and inadequate management. They proceed to revamp the company debt structure and recruit new management to enhance operational processes.
The possibility of a private equity takeover can be seen as advantageous for companies in need of significant, long-term restructuring, despite the undesirable nature of debt accumulation.
Pros and cons of private equity
Having a private equity investor comes with the benefit of gaining access to not only capital but also their knowledge in the industry. If the investor has relevant experience, they may assist in identifying potential areas for growth.
A private equity investor typically acquires a majority stake in the company and therefore possesses decision-making authority in terms of operational changes, including executive dismissals.
Private equity investors have the authority to consider selling a company based on financial benefits. It is possible for them to explore potential opportunities for selling, as their primary goal is profit making.
When investors are brought on board, a degree of control over the business will be relinquished.
Private Equity vs. Venture Capital: The Lines Have Blurred
Several venture capital firms have shifted their focus towards growth equity and investing in later-stage companies.
Accel and Sequoia, two well-known U.S.-based venture capital firms, have recently raised growth funds of approximately $1 billion USD or higher. As a result, they are now seeking investment opportunities worth tens of millions or even $100 million+ through these funds. Several traditional private equity firms have expanded into growth equity, such as KKR with their “Next Generation Technology Fund”.
Many traditional beliefs on how companies should raise capital are no more valid. Venture lenders are now offering debt financing to a significant number of startups that have yet to generate revenue. It is possible for a technology startup to raise both debt and equity as it progresses from pre-revenue stages to becoming a publicly traded entity.
Although traditional leveraged buyouts employ both debt and equity, there has been a notable increase in the percentage of equity used from less than 10% in the 1980s to 40-50% more recently.
Private Equity vs. Venture Capital: Main Differences
Difference #1: Company Types
Venture capitalists typically direct their attention towards the technology and life sciences sectors, while private equity firms tend to invest in a broader range of industries. The percentages allocated to sectors such as media and entertainment, energy, and consumer products may fluctuate on a yearly basis. Some industries are often avoided by traditional private equity firms due to specific regulatory limitations, such as commercial banking.
Difference #2: Percentage Acquired and Deal Size
According to the research, private equity deal sizes range from $100 million to $10 billion, while venture capital deal sizes are typically under $10 million. However, It is advisable to approach these figures with some skepticism.
The term “under $10 million” deal size is typically associated with Series A rounds, which denotes the initial significant capital obtained by a company. As a company progresses to Series B, C, and D, the size of the deals generally increases significantly.
The average fundraising amount varies among different industries. Cleantech and life sciences companies usually require a higher amount of capital compared to software startups, resulting in larger funding rounds.
While the average leveraged buyout in a developed market on the private equity side may be hundreds of millions USD, there are still deals that are smaller than that.
Difference #3: Value Creation / Source of Returns
For venture capital, returns continue to rely on the growth of a company and its subsequent increase in valuation over a period.
Many private equity firms have been observing a trend in that direction.
In cases where firms utilize higher levels of equity, typically around 40-50%, a focus on EBITDA growth becomes more crucial as opposed to relying solely on “financial engineering” for returns during acquisitions with lower equity contributions of 10%.
Difference #4: Operational Focus
Many VC firms tend to have a higher level of involvement in a company’s operations than what is generally perceived. Andreessen Horowitz is an example of a company with operational teams providing support for executive functions like recruiting, sales, and marketing.
Private equity firms, particularly in the middle market, tend to prioritize enhancing operational performance.
Difference #5: Investment Goals and Timeline
Venture capital firms typically seek to invest in early-stage companies with high growth potential. Their goal is to help these companies reach their full potential and eventually exit the investment with a significant return on investment.
Private equity firms, on the other hand, often invest in established companies that have already demonstrated some level of success. Their goal is to improve the company ‘s performance through operational improvements, strategic acquisitions, and other means. Private equity firms usually have a shorter investment horizon than venture capitalists, typically aiming to exit their investments within three to seven years.
Conclusion
Both venture capital and private equity aim to generate returns for investors by investing in companies, but there are notable distinctions between the two. These include the industries they invest in, the size of deals they make, their sources of returns, areas of focus, and investment objectives and timelines. It is crucial for entrepreneurs seeking funding to comprehend these variations so as to select the suitable investor type for their enterprise.
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