Private Equity vs Venture Capital: Critical Differences
Private equity and venture capital play critical roles in a company's growth. It’s important to know the differences between them.
What is private equity?
Making the decision to take on external funding should not be taken lightly. A decision to bring on additional capital and more importantly, where that capital comes from, can make or break a business if not fully understood. Two types of investment that a new business or startup might consider are private equity and venture capital. Private equity and venture capital play critical roles in a company’s growth. At their core, private equity and venture capital may seem similar, however, the types of companies each type of funding typically invests in and how much they invest differ quite a bit.The firms involved in each type of funding are very different as well. It’s important to know the differences between them if you are a founder looking to take on new funding.
At the simplest level, private equity is capital that is invested in a company or other type of private entity that is not publicly listed or traded. More detailed, private equity is a compilation of funds sourced from firms as well as high net-worth individuals. The purpose of these firms is to invest in private companies by buying large amounts of shares. Additionally, private equity can also mean buying the majority of a public company with the intention of taking it private and delisting it from the public stock exchange. The majority of the private equity world is dominated by large institutional investors. These large institutional investors typically include large private equity firms and pension funds. A pension fund is any plan, fund, or scheme which provides retirement income. These funds are typically larger and well equipped to be invested into private companies.
How does private equity work?
Private equity firms hold roughly $4 trillion assets annually. The breakdown of private equity investments comes from two major types of investors. The two types of private equity investors are:
- Institutional investors, primarily pension funds or major banks
- Large private equity firms
The typical goal of private equity investments is to gain control of a company through a full buy-out or a majority investment in said company. With total control being the main focus and purpose of private equity investments, lots of capital is needed. Therefore, typically the funds involved in private equity need to be large and stable.
Large private equity funds and institutional investors are made up of accredited investors. Most private equity funds have a minimum requirement. These minimum requirements set the minimum amount of money that an accredited investor must commit to the fund in order to be a part of the fund. These minimums are significant. A standard one might be $250,000 – $500,000.
Private equity firms focus on two main functions. These functions are deal origination and management, and portfolio oversight.
refers to managing overall deal flow. This is done by relationship management and deal management – creating, maintaining, and developing relationships with M&A (Merger and Acquisitions) intermediaries, investment banks, other transaction professionals in the space. This focus allows private equity firms to build a strong network for referrals and new opportunities to invest and purchase companies. In the robust M&A landscape, it is also common for private equity firms and institutional investors to employe folks specifically focused on prospecting companies where a future opportunity to buy or invest could occur.
Portfolio oversight is the overall management of all active investments in the private equity firm’s workflow at any given time. Any active investments make up a portfolio. Managing that day in and day out consists of advising and directing revenue strategies, monitoring profitability, making hiring and executive decisions, and overall monitoring if the portfolio is balanced and profitable. The level of work in each investment will vary depending on how large and what stake of ownership the firm has. Financial management will be the main focus but IT procurement and operational tasks are typically part of that as well.
Outside of traditional large cash, equity or debt investments, a common strategy for private equity firms is the leveraged buyout strategy or LBOs. An LBO is a complete buy-out where a company is bought out by a private-equity firm, and the purchase is financed through debt. The collateral for that debt is the company’s operations and assets.
Examples of Private Equity Firms
Holding trillions of dollars in capital, there are plenty of private equity firms out there. The top 10 globally are:
- The Blackstone Group
- Neuberger Berman Group LLC
- Apollo Global Management Inc.
- The Carlyle Group Inc.
- KKR & Co. Inc.
- Bain Capital LP
- CVC Capital Partners
- Warburg Pincus LLC
- Vista Equity Partners
- and EQT AB.
Most of the largest firms have global offices spanning New York to San Francisco to Hong Kong to Paris and many other major hubs in between as well as across all populated continents.
On the institutional investor side, JP Morgan Chase, Goldman Sachs, and Citigroup are all prominent players within the private equity space as well.
Private Equity Backed Companies
Private Equity firms can invest in a variety of different types of companies. A few examples of well-known companies that are backed by private equity firms include:
- Hostess Brands – the sweets company
- ADT Inc. – a leading provider of monitored security
- Qdoba – the fast food brand
- Infoblox – software security
- Marketo – sales and marketing software
- Powerschool – education technology
- LogicMonitor – SaaS performance monitoring
What is venture capital?
Venture capital is also a form of private funding. More specifically, venture capital is funding given to startups or other young and new businesses that have the potential to break out of their category and grow rapidly, finding success. Venture capital funding typically comes from wealthy individual investors, banks, or other financial institutions. Notably, a venture capital investment is typically financial but could also be an offer of technical or managerial experience. Venture capital is all about the risk and reward balance. Venture capital investors invest in companies that have not proven success yet but show major potential and the opportunity to make back higher than typical returns if the company delivers at the high potential the venture capitalists believe that it will.
Related Resource: 12 Venture Capital Investors to Know
How does venture capital work?
Venture capital in a nutshell is private equity but specifically for small startups and new companies with high-growth potential in the technology, biotechnology, and clean technology spaces. Venture capital is technically a form of private equity, however, it is a type of investing that is normally all equity and smaller investments than other private equity investments. The main differentiator is that venture capital is focused on high-risk, high-reward scenarios.
There are three main types of venture capital financing:
- Early-stage – this is typically a small amount of funding, potentially in a seed round, that allows a startup to finish building a product or service offering, qualify for a loan, or in some cases kick-off early stage operations.
- Expansion – this type of venture funding is typically a higher capital amount that will allow a startup to scale rapidly. The type of funding might be seen at a Series A or larger.
- Acquisition – this type of funding may be purposed specifically for financing the buyout of another company or competitor in that startups space. It might also be used to develop a new type of product or launch a new line of business within their company.
Just like private equity firms, venture capital firms offer capital for equity. Investors from venture capital firms often take board seats as part of their ownership / equity stake in a company.
Venture capital firms typically raise set funds with teh intention of investing those funds over the course of a set period of time. The funds are typically made up of individual investments from limited partners, or wealthy individuals, banks, or other institutional investors. LPs invest their money in venture capital firm’s funds because they are looking for high-growth returns and trust the venture capital firms to make those investment decisions for them.
Venture capital firms typically employ a staff dedicated to researching the potential investments that could be made. Because of the high-risk high-reward industries that VCs work with, due-diligence and detailed research is crucial to eliminate as much risk as possible before investing firm dollars in a startup.
Examples of Venture Capital Firms
With tech startups historically being founded in the Bay Area and other major metro hubs like New York City, a large portion of VCs are based on the coasts. A few well-known venture capital firms include:
- Bessemer Venture Partners
- Sequoia Capital
- Andreesen Horowitz
- GGV Capital
- Index Ventures
- Founders Fund
- and IVP
Examples of VC backed companies
Most high-growth, successful tech companies, especially SaaS companies, are venture backed. Well known venture-backed companies include:
- Pinterest – the visual bookmarking tool
- LinkedIn – world’s largest professional network
- Yelp – online directory for local restaurants, services, retail, reservations and recommendations
- Docusign – digital documents
- Hubspot – marketing and sales software
- Instagram – photo sharing social platform
Private equity vs venture capital for startups
The main difference between private equity and venture capital comes down to size and risk.
What Private Equity Firms are Looking For (in startups)
Private Equity firms typically are looking for large companies with a proven track record to buy. They are looking for mature businesses where the model is proven out. These large or more mature companies may be failing for one reason or another. Even if a company is not necessarily failing but instead has plateaued their growth, a private equity firm would look to buy the company and streamline operations to make it more capital efficient, cash positive, and profitable. Private equity firms mostly buy 100% ownership of the companies in which they invest. Typically then the companies are in total control of the firm after the private equity buyout. Private equity investments are also typically a minimum of $100M for one single company. There are no limits for the type of companies private equity companies can invest in. In addition to equity, private equity firms may structure investments with debt and cash.
What VC Firms are Looking For (in startups)
Venture capital is typically invested in a new company with high potential. This could be a small startup or a larger scaling startup that has yet to reach profitability but is showing major upside and potential. Unlike private equity, venture capital firms typically invest less than 50% in any one company or investment. Due to the high-risk nature of the companies they are investing in, they typically like to spread the money in their funds across many different investments to increase their chance of success and high return. The investments from venture capital firms are typically less than $10M per investment. Venture capital firms are limited to startups in technology, biotechnology, and clean technology. Additionally, venture capital firms typically only invest with equity.
For startups early on in their journey, venture capital is typically where they might seek investment. This is due to the early risk of their companies as well as the desire to maintain majority control in their companies management and direction as they build. Down the line, a startup may end up in the position where their only option is to give away the majority stake in their company to inject capital into the business to keep it afloat.
Critical differences between venture capital firms and private equity firms
The difference between private equity and venture capital matters because the type of investor a company brings into their business can completely shape the outcome and ultimate goal of the company. Understanding your desire to IPO, get acquired, or stay private are critical to consider before seeking different types of funding. Ownership and advisory can make or break a successful company as well as change the type of value and long-term financial success of the founders or initial employees.
Related Resource: How to Choose the Right Law Firm for Your Startup
When to seek out Private Equity vs Venture Capital
As a startup, it’s important to understand when to seek out private equity or venture capital backing throughout your company’s journey. Taking on the right type of investors (or not) at the right time is critical for long-term success.
Startups in the tech space will most commonly seek out venture capital funding first. If a startup is in the tech space and is aiming to grow quickly and make it big or believes it has the potential in a large market to take a large market share, venture financing makes sense as it allows that company to scale quickly without giving up too much equity or majority stake.
Companies in a position where they heed a large injection of cash, are not in the startup technology space, or are not high-risk, might make more sense to seek funding from a private equity firm. This type of investment may lead to a larger stake of control being put forward but with more stable and long-term financing options.
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