For many entrepreneurs, when raising capital to fuel company growth, they almost always turn to venture capitalists. Very few entrepreneurs really understand private equity as a form of investing in the early stages of company growth. They can actually understand very little about this type of investor as a potential investment option. But what if you are/were an entrepreneur whose company business model generated revenue 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? Do you really need venture capital or are you a candidate for private equity financing? Before we look at the main differences between private equity and venture capital, let’s review the private equity market.
After a year of pandemic-induced turbulence that dampened fundraising and deal activity, private markets have rebounded across the board. McKinsey’s annual review of private markets shows that private equity has risen to new heights. Fundraising in 2021 is up nearly 20% year over year to reach a record of nearly $1.2 trillion; traders were busier than ever, allocating $3.5 trillion across asset classes; and assets under management (AUM) rose to an all-time high of $9.8 trillion as of July, up from $7.4 trillion a year earlier. Will private equity give traditional venture capital a run for its money in terms of entrepreneurs? Well, it depends.
First, let’s look at the key definitions of both, then review the main differences.
What is private equity? Private equity refers to investments in company shares that are not publicly listed. 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. A private equity firm brings value by infusing cash, restructuring debt, providing more resources and talent. This can really scale a smaller firm that wants to compete in a larger market. If a solid management team is in place, investors are traditionally more distant from the company’s management.
What is venture capital? Venture capital is a financial investment for new startups and emerging companies that 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 identify promising high-growth startups or emerging companies. The group will initially purchase a minority stake in the company and use its collective funds to grow the business. Venture capitalists are more involved in the growth and management of the company with board meetings, relationships and more oversight of the company.
So, now that you may understand a little more about private equity and venture capital, let’s look at the main differences between the two investment strategies.
Growth stage of the company. Private equity firms tend to invest in or buy companies with solid revenue or cash flow, while venture capitalists typically invest in startups and early-stage growth companies that have high growth potential.
Company type. When you compare private equity and venture capital, one of the main distinguishing characteristics is the types of companies each supports. Private equity firms often have diverse portfolios that span all industries, from healthcare to construction, transportation to energy. Contrary to this broad scope, venture capitalists typically have a narrow focus on technology or innovative companies (such as biotech).
Actual investment amount. 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 capital acquired. A key difference between private equity and venture capital is that private equity firms typically buy a majority stake or the entire company, while venture capitalists get only a portion. If they don’t get 100%, at least a private equity firm will provide the majority stake, effectively claiming the company’s autonomy. Most of the time, VCs will receive somewhere between 10-20% equity in a Series A round of investment. They can raise more capital in subsequent rounds if needed.
Risk appetite. Venture capitalists expect that most companies they back 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 firms make a relatively small number of investments, 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 target more mature companies with solid revenue and cash flow, as the probability of failure is greatly reduced.
Return on investment. Both private equity firms and venture capital investors aim for a 20% internal rate of return (IRR). However, more often than not they usually fail. For venture capitalists, returns depend on the success of just a few top companies in their portfolio. By comparison, private equity returns can come from any number of companies, even those that are not as well known.
So, as an entrepreneur, which one is best for you? It depends on a number of factors, including the type of company you have, the current stage it’s at, and your business goals. 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 time, private equity may be the best choice. On the other hand, if you want to innovate or disrupt an industry and become an important player in the market and you need strategic partners to grow your company together, you should choose venture capital. Whatever you decide, seek good advice and choose wisely.