When it comes time to support substantial growth in your business, choosing between venture capital and private equity funding could be a defining moment in your company’s evolution. Both sources of capital can allow your business to ascend to the next level of operations, but is one more advantageous than the other? A solid understanding of the benefits and drawbacks of private equity vs. venture capital will help you make an informed decision as you map the future of your endeavor.
What is private equity?
Private equity refers to a type of capital that is provided to established businesses in exchange for ownership in the company. Implied in the private equity meaning is that the company receiving the investment is private, not publicly traded. Private equity firms are responsible for selecting and managing the companies they purchase, either partially or completely, on behalf of outsiders who invest in private equity funds. The benefits of private equity investment include the ability to directly influence business decisions and potentially high returns when the PE firm exits the business.
What is venture capital?
Venture capital refers to funds invested in businesses carrying a significant amount of financial risk, typically new (startup), expanding, or otherwise unproven companies. This might also include businesses lacking the resources to scale up a proven business model. Venture capital investments aim to generate high returns by fostering innovation, supporting growth, and eventually realizing gains through an initial public offering (IPO) or acquisition.
5 differences between private equity and venture capital
It’s no surprise that private equity and venture capital are often confused with one another. Venture capitalists are actually a subset of private equity investors. Both VC and PE firms raise money for business expansion opportunities from pools of interested investors, including institutional capital (pension funds, insurance companies, etc.) as well as high net worth individuals. Both invest private capital and purchase shares in private companies, as opposed to publicly traded companies. However, the private capital definition is slightly different for private equity vs. venture capital. In general, private equity is intended to optimize the operations and profitability of established companies, while venture capital tends to focus on funding early-stage startups.
Here are a few of the most important factors that define venture capital funding vs. private equity investment.
1. Investment stage
Venture capitalists typically invest smaller amounts of money across a diverse portfolio of startups, expecting that some may fail while others generate substantial returns. The financial structure often involves multiple rounds of funding, such as seed, Series A, B, C, etc., and these rounds may get progressively larger if the business is meeting its goals.
On the other hand, private equity firms often use a combination of equity and debt to finance a much larger investment in a more proven business. Since the stakes are higher, they perform significant due diligence to ensure both the structure and cash flow of targeted businesses are stable. This vetting process might also include thorough financial analysis, market research, and operational assessments.
2. Risk profile
A risk profile is determined based on a combination of the likelihood and impact of a financial loss for a given investment. The risk profile of a venture capital investment is typically much larger than that of a private equity investment. While private equity encompasses a wide spectrum of investment types, venture capital often focuses on early-stage startups that may have unproven business models, and therefore a higher risk of failure. Private equity firms often mitigate investment risk further by taking an active role in company leadership and decision-making.
3. Target investments
Private equity firms tend to purchase majority ownership of established companies in a transaction. They see an opportunity to increase enterprise value by implementing operational efficiencies or innovating new products or services. PE companies make these household-name businesses even better, then sell them for a profit down the road with a clear exit strategy from day one. This allows them to realize substantial returns on their investment while ensuring that the companies they enhance will thrive over the long run.
Rather than seeking mature businesses, venture capital firms tend to target start-ups with the potential for exponential growth. They usually purchase minority stakes (less than 50%) to alleviate the risk of putting all their proverbial eggs in one basket. Unlike private equity firms, which can cast a wide net in terms of business sectors, most venture capitalists specialize in an emerging market, such as software and app development, biotechnology, or artificial intelligence (AI).
4. Funding size and type
Private equity firms range dramatically in the sizes of companies they target and how much money they invest in each business. While the mainstream media typically covers larger PE firms that invest billions of dollars, a substantial number of them make investments in smaller businesses poised for growth and expansion. PE portfolios tend to include established companies with sustainable cash flows and more moderate growth opportunities.
VCs, on the other hand, often take a greater risk by investing in promising but unproven start-up companies. They usually put no more than $10 million into a single deal and try to spread around their available funds to mitigate the risk of loss if a company doesn’t pan out as planned. Further, while private equity firms may offer a combination of equity and debt, VCs typically fund opportunities with equity only.
5. Responsibilities and involvement
Private equity firms tend to take a more active role in restructuring and strategic initiatives to boost the value of acquired businesses. These changes can also have a strong impact on the company culture. While venture capital firms may also provide mentorship and strategic guidance to businesses in their portfolio and may have a seat on the board of directors, they are usually not involved in day-to-day operations. This might be considered a benefit for businesses seeking to raise capital while retaining more control.
Partnering with a private equity firm
PE provides access to more than just money. If you choose an investment firm with expertise in your area, you can take advantage of their accumulated knowledge and resources as you move into your next phase of growth.
Because private equity investors have a significant ownership stake, they often influence the company’s direction and operations. While some business owners have concerns about giving up their independent status, many welcome the chance to partner with a team seasoned in growing companies in their sector. If you are interested in growth and a new vision for the future of your business, guidance from the right PE partner can accelerate expansion and innovation.
Venturing into the venture capital world
As a start-up poised for rapid expansion, you may attract the attention of venture capitalists who fund companies like yours in their early-to-mid growth stages. VCs have niche expertise and bring connections to the table that can build your professional network. With a smaller stake in the process, however, they tend to be more hands-off than PE firms.
Venture capital and private equity principals continue to guide the direction of many burgeoning businesses. Blockchain platform Ripple Labs, self-driving innovation firm Waymo, and online payment processor Stripe all used venture capital to scale their products and services.
The bottom line
When your company needs financing to facilitate growth, a strong pitch will help attract VC or PE funding, depending on your intended audience. Both types of investors look for businesses that can produce future profits with solid offerings, leadership, and vision. Understanding the similarities and differences between private equity and venture capital can ensure your business receives the growth capital it deserves.