In A Tough Investment Market, Entrepreneurs Need To Understand The Differences Between Private Equity And Venture Capital
For quite a few entrepreneurs, when raising capital to fuel the growth of the company, they almost always turn to venture capital investors. Very few entrepreneurs really understand private equity as a form of investing in the early stages of a company’s growth. They may actually understand very little about these types of investors as a potential investor option. But what if you are/were an entrepreneur whose company’s business model generated revenue out of the gate in the first month and your team was able to grow the company to $1-2 million in revenue with little debt and good cash flow? Would you really need venture capital or are you a candidate for private equity financing? Before we look at the key differences between private equity and venture capital, let’s review the private equity marketplace.
After a year of pandemic-driven turbulence that suppressed fundraising and deal activity, private markets have rebounded across the board. McKinsey’s Private Markets Annual Review indicates that private equity has risen to new heights. Fundraising in 2021 was up by nearly 20% year over year to reach a record of almost $1.2 trillion; dealmakers were busier than ever, deploying $3.5 trillion across asset classes; and assets under management (AUM) grew to an all-time high of $9.8 trillion as of July, up from $7.4 trillion the year before. Is private equity going to give traditional venture capital a run for its money with regard to entrepreneurs? Well it depends.
First, let’s look at the key definitions for both, then review the key differences.
What Is Private Equity? Private equity refers to investment in company shares that are not publicly listed. This investment capital is provided by individuals or firms with a high net worth. Generally, private equity firms like to take control of a private or public company. The private equity firm brings value by infusing cash, restructuring debt, providing more resources and talent. This can really scale a smaller firm looking to compete in a larger marketplace. If a solid management team is in place, the investors are traditionally more hands off in running the company.
What Is Venture Capital? Venture capital is financial investment for new startups and emerging companies, which is provided by wealthy individuals known as venture capitalists. Typically, several venture capitalists pool their resources, and outside investors, to form a limited partnership and they identify promising startups or emerging high-growth companies. The group will initially buy a minority equity stake in the company and use their collective funds to grow the business. Venture capitalists are more involved in the growth and management of the company with board meetings, connections and more company oversight.
So, now that you might understand a little bit more about private equity and venture capital, let’s look at the key differences between the two investment strategies.
Stage of company growth. Private equity firms tend to invest or buy companies with solid revenue or cash flow, while venture capitalists usually invest in startups and companies in the early stages of growth that have a high potential for growth.
Type of company. When you compare private equity vs venture capital, one of the major differentiators is the types of companies they each support. Private equity firms often have diverse portfolios that cover all industries, from healthcare to construction, transportation to energy. Contrary to this wide scope, venture capitalists usually have a narrow focus on technology or innovator companies (like biotech).
Actual investment size. According to PitchBook, 25% of private equity deals in the U.S. are between $25M and $100M. Many venture capital deals are less than $10M in Series A rounds, though subsequent funding rounds can be much larger.
Percentage equity acquired. A key difference between private equity and venture capital is that private equity firms usually purchase a majority share or the entire company, whereas venture capitalists only get a portion. If they don’t get 100%, at the very least a private equity firm will secure the majority share, effectively claiming autonomy of the company. Most of the time, venture capitalists will receive anywhere from 10-20% equity in a “Series A” round of investment. They can gain more equity in subsequent rounds if they are needed.
Appetite for risk. Venture capitalists expect that the majority of companies they back will eventually fail. However, the model works because they hedge their bets by investing small amounts in lots of companies. This strategy would never work for private equity firms. While PE firms make a relatively small number of investments, each acquisition is significantly more expensive. It only takes one company to fail and the entire fund may be impacted. This is why private equity firms target more mature companies with solid revenue and cashflow, as the probability of failure is greatly reduced.
Return on investment. Both private equity firms and venture capitalist ‘s target a 20% internal rate of return (IRR). However, more often than not, they usually fall short. For venture capitalists, the return hinges on the success of just a few top companies in their portfolio. By comparison, private equity returns can come from all sorts of companies, even ones that aren’t as well-known.
So, as an entrepreneur, which one is best for you? It depends on a multitude of factors, including the type of company you have, the current stage it’s at, and your business objectives. If you have the type of company that can generate revenue and cash flow quickly, you have more options to stay away from giving up equity or taking on debt early in the company’s life. If your goal is simply to make a lot of money in a short space of time, private equity might be the best choice. On the other hand, if you want to innovate or disrupt an industry and become a significant player in the marketplace, and you need strategic partners to grow your company together, you should go with venture capital. Whatever you decide, seek good advice and choose wisely.