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In a tough investment market, entrepreneurs need to understand the differences between private equity and venture capital

admin by admin
November 22, 2022
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Founding team of entrepreneurs discussing whether to pursue private equity or venture capital … [+] investment.

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For quite a few entrepreneurs raising capital to drive business growth, 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 understand very little about this type of investor as a potential investor option. But what if you are/were an entrepreneur whose business model generated revenue in the first month and your team was able to grow the business to $1-2 million in revenue with little debt and good cash flow? Do you really need venture capital or are you a candidate for private equity financing? Before looking at the key differences between private equity and venture capital, let’s take a look at the private equity market.

After a year of pandemic-induced turbulence that dampened fundraising and deal activity, private markets have rebounded across the board. Annual Review of McKinsey’s Private Markets indicates that private equity has risen to new heights. Fundraising grew nearly 20% year over year in 2021 to a record close to $1.2 trillion; dealmakers were busier than ever, betting $3.5 trillion across various asset classes; and assets under management (AUM) grew to a record high of $9.8 trillion in July, from $7.4 trillion the year before. Will private equity put traditional venture capital to the test with entrepreneurs? It depends.

Let’s look at the main definitions for both first and then look at the main differences.

What is Private Equity? Private equity refers to investments in company shares that are not publicly traded. This investment capital is provided by high net worth individuals or companies. In general, private equity firms like to take control of a private or public company. The private equity firm adds value by injecting cash, restructuring debt and providing more resources and talent. This can really scale a smaller company looking to compete in a larger market. Traditionally, when there is a solid management team, the investors are more hands-off in running the business.

What is venture capital? Venture capital is a financial investment for new startups and emerging companies, provided by high net worth individuals known as venture capitalists. Usually, several venture capitalists pool their resources and outside investors to form a limited partnership and identify promising startups or emerging high-growth companies. The group will initially purchase a minority stake in the company and use their collective resources to grow the business. Venture capitalists are more involved in the growth and management of the company with board meetings, connections and increased corporate oversight.

So, now that you may understand a little more about private equity and venture capital, let’s take a look at the key differences between the two investment strategies.

investment agreement

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Stage of business growth. Private equity firms tend to invest or buy companies with solid income or cash flow, while venture capitalists usually invest in early-stage startups and companies with high growth potential.

Company type. When comparing private equity versus venture capital, one of the key differentiators is the types of companies they each support. Private equity firms often have diverse portfolios spanning all sectors from healthcare to construction, transportation to energy. Contrary to this broad scope, venture capitalists tend to have a narrow focus on technology or innovative companies (such as biotech).

Actual size of investment. According to PitchBook, 25% of US private equity deals are between $25 million and $100 million. Many venture capital deals are under $10 million in Series A rounds, although subsequent funding rounds can be much larger.

Percentage of equity acquired. A key difference between private equity and venture capital is that private equity firms usually buy a majority share or the entire company, while venture capitalists only get a share. If they don’t get 100%, at least a private equity firm will secure the majority stake and basically claim the company’s autonomy. Typically, venture capitalists receive 10-20% equity in a “Series A” investment round. They can get more equity in subsequent rounds if needed.

Hunger for risk. Venture capitalists expect that the majority of the companies they support will eventually fail. However, the model works because they hedge their bets by investing small amounts in many companies. This strategy would never work for private equity firms. While PE companies make relatively little investment, each acquisition is significantly more expensive. It only takes one company to go bankrupt and the entire fund can be affected. This is why private equity firms are targeting more mature companies with solid earnings and cash flow, as the likelihood of bankruptcy is significantly reduced.

Return on investment. Both private equity firms and venture capitalists aim for an internal rate of return of 20% (IRR). However, they usually fall short. For venture capitalists, returns depend on the success of only a few top companies in their portfolio. By comparison, private equity returns can come from all kinds of companies, even lesser-known companies.

So, as an entrepreneur, which one is best for you? It depends on many factors, including the type of business you have, the current stage it is in, and your business goals. If you have the type of business that can generate income and cash flow quickly, you have more options for not giving up equity or taking on debt early in the business’s life. If your goal is simply to make a lot of money in a short period of time, private equity may be the way to go. On the other hand, if you want to innovate or disrupt an industry and become a major player in the market, and you need strategic partners to grow your business together, you need to use venture capital. Whatever you decide, seek good advice and choose wisely.

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