Private Equity vs. Venture Capital | In- Depth Guide
You have probably heard Private Equity (PE) and Venture Capital (VC) being discussed a lot in the startup world. What is the difference between private equity and venture capital? Do both types of investments focus on the same companies? What types of firms specialize in private equity, and what types of companies specialize in venture capital?
These are just some of the questions that often arise when seeking investments. And, in truth, although they may seem similar, they have some quite marked differences. In this article we will try to delve deeper into them.
What is Private Equity (PE)?
Private equity could be defined as a firm that buys outright or at a minimum controlling share companies. The acquired companies can be public or private. In the case of public companies, this is often referred to as taking the company private and as a result delisting all equity and debt instruments from public exchanges. These type of firms take charge of managing the companies they buy to increase their value and then sell them. Individuals involved in private equity generally do not have a stake in publicly traded companies. Each private equity firm has their own investment thesis and investment horizons that they are stewarding to.
Typically, private equity firms looks for depressed valuations, strong recurring revenues and competitive or regulatory positioning that afford the portfolio company a form of protection. The PE firm uses its financial and non-financial resources to optimize the company’s value before they sell the portfolio company to another PE firm, Management, Holding companies, or list the company on a public stock exchange.
What constitutes a controlling interest?
Controlling interest does not adhere to a bright line test and it is situation specific based upon the Universal Shareholders’ Agreement (USA) and the Articles of Incorporation. The USA defines what constitutes an ordinary and a special resolution. To put in layman terms a shareholder has control over a corporation if they control the Board votes. For example, they have 3 of the 5 Board seats. Or they own 50+% of the shares in a corporation in the case of simple majority. However, a shareholder does not have to have to own 50% or more of the shares.
Recommended reading: Advisory Shares | What are they and how do they differ from others?
What is Venture Capital (VC)?
Venture Capital is a form of Private Equity. Although it is a form of private capital, because Venture Capital is one of the forms in which private equity is presented, the term private equity is not commonly used to refer to Venture Capital.
VC firms are organized as follows:
- A firm that acts as the General Partner. This is the company that actively raises, manages and administers a fund.
- A firm holds the investments from the Limited Partners participating in a fund.
Typically, VC firms are looking to make investments that they believe hold great development potential in the future. They go after companies with Big Hairy Audacious Goals (BHAGs) and big Total Addressable Market (TAM).
Who can be a Limited Partner?
Generally speaking these are accredited investors, corporations, financial institutions and government. The bigger the size of the fund that the VC firm raises, the bigger the size of the organization that participates in a fund. It is fairly common for VC firms to co-invest or to participate in a fund of another VC firm.
The largest LP cheques come from institutional investors and asset management firms (think pensions funds, university endowment funds, sovereign wealth funds, etc.).
Venture Capital vs. Private Equity: Top 10 Differences
So what are the differences between venture capital and private equity:
1. Type of companies they focus
The main difference between venture capital and private equity is that, while venture capital chooses to invest in earlier stage companies with great development potential. Private equity chooses later stage, mature companies that are struggling because of inefficient leadership, poor liquidity, inefficient processes, etc. leading to a depressed valuation for a given company.
2. Level of risk
Venture capital investments tends to be significantly higher risk than private equity investment. VC investments tend to focus on early stage companies that are redefining existing or creating new industries. High risk, high potential rewards. On average, VC firms invest in 0.5% of the companies that they evaluate. As such, dealflow is a key area focus for VC firms and many of the deals that VC firms invest in are syndicated.
3. Control over the business
First, keep in mind that you will always lose some control over your company. Private Equity firms seek control over the business while Venture Capital firms typically take up to 25% of the company as part of a financing round. VC firms was the founding team to have as much “skin” in the game as possible in order to drive forward with zealousness. VC firms rely on the founding team and the leadership team to execute on their vision where as PE firms set the vision.
4. Amount of return
Typically, the venture capital returns of a well managed funds produces significantly higher returns than private equity, even though venture capital is riskier. The typical fund has 10% to 20% of the companies generate almost all of the returns. In a fund of 10 companies, 1 or 2 or the soonincorns/unicorns, 4 to 6 generate modest returns, and 1 or 2 turn out to be failed investments.
5. Type of growth
While venture capital investors are interested in long-term growth, private equity investors are only interested in solving the company’s problems as quickly as possible, so that they can sell it faster. Generally speaking PE firms have shorter investment horizons although this is not true in all cases.
6. Type of investors
The venture capital investors (aka Limited Partner) usually are high net-worth individuals (typically accredited investors although the securities and exchange commission have started to relax the rules), investment banks or specialized VC funds. Private equity capital primarily comes from institutional investors: asset management firms, pension funds, endowment funds, banks, etc. The most notable exception are family offices. Family offices are typically focused on private equity investment and as the name suggests the money for the investment comes from one high net-worth family.
7. Amount of money invested
This is highly dependent upon the fund raised and the stage of companies that they invest in. Generally speaking VC firms usually usually write checks ranging between 500K and 100M. On the other hand private equity investors usually spent 100 million dollars, because the company they choose is already established. But the two investments have a significant overlap in terms of cheque sizes.
8. Industries they focus on
VC firms usually focus on startups oriented in new and emerging industries (e.g. technology, biotechnology and clean technology), etc.), while PE firms focus on more established and mature industries where they can drive market consolidation.
9. Number of businesses they focus
VC firms typically invest in a multitude of startups at the same time through one of their funds. A typical fund’s life is 7 years with 2+2 years to extend + wind down the fund. A successful VC firm start raising a new fund 2 to 3 years into the life of an existing fund. As such a successful firm can have 4 to 6 funds at the same time. On the other hand, private equity investors only focus on several established businesses.
10. Resources used for the investments
Venture capital firms acquire ownership in a company through the investment of capital and provision of services. Private equity investors, on the other hand, use capital to acquire full or controlling ownership of a company.
Which is better: private equity or venture capital?
It always depends on what you are looking for, the outcome that you are seeking to achieve, the time horizon in mind, etc.
If you are looking for an exit, you are not looking to continue with the company, there is an immediacy of need, the company valuations are well established and understood in the industry, and so forth, then the PE route is a better choice.
However, if you are blazing a path in a new industry, the market size is very large, the funding needs will be continuous, customer revenue may not yet be visible on the horizon, you are on a journey that will take many years to execute, you want to stay on with the company in a leadership capacity, then the VC route is the clear winner.
Which is riskier: private equity or venture capital?
From an investment standpoint, venture capital investments are usually riskier than private equity investments. Higher risk typically leads to a higher rewards. This is due to the fact that the former focus on startups that have a great potential for future development, but are not yet fully established in the market. In any case, you should keep in mind that the return on investment is also usually higher. If you are considering becoming a LP, make sure that you have clear understanding of the risk associated with the investments and that you employ an asset and investment diversification strategy.
3 examples of Private Equity and Venture Capital firms
1. The Blackstone Group Inc (Private Equity)
This company was founded in 1985, and is currently one of the largest private equity firms. This is not only because it has $881 billion in assets under management (AUM) but also because it has $126 billion invested in private equity projects.
It has more than 107 companies in its portfolio, including the dating application Bumble and the financial market data and infrastructure provider Refinitiv.
2. 8VC (Venture Capital)
8VC is a relatively new venture capital firm, having been founded in 2015. However, it already has 278 realized investments, and currently manages over $2.7 billion in AUM.
This company focuses primarily on early-stage startups, and seeks to foster technological innovation with strategic support and monetary incentives.
3. Future Ventures Corp. (Family Office)
Future Ventures is a clear example of a family office. The company focuses primarily on startups and young companies that are mainly oriented to the B2B market, although it also has some B2B and B2C oriented companies in its portfolio.
Some of the industries in which they have invested are: Real Estate, Prop Tech, Loyalty Rewards, Blockchain, Travel and Agriculture.
As you can see, there are quite a few similarities between a venture capital and private equity firm. The delineation is not as clear-cut as one may expect. However, there are several notable differences between private equity investments and venture capital investments. Because of this, it is necessary to fully take into account your personal and company situation before selecting one route over another.
Taking on external capital comes with external reporting needs and more stakeholders to manage. As such, “date” your potential investors. Do your due diligence. Go and get references from other companies the investor has invested in. Do you see yourself working well together with this investor? Are your visions for the company aligned? Bringing an investor on board is akin to marriage. You are in it for the long haul and you have to be 100% committed to making it work.
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