Venture Capital vs Private Equity: All you need to know
Venture capital and private equity, though different, have often been used interchangeably. However, it is critical to understand the difference between them (venture capital vs private equity) to determine which one would be suitable for your business. In this blog post, we will tell you what each of these funding sources is, how they work, and the key differences between venture capital and private equity. Read along!
What is venture capital, and how does it work?
Venture capital is a type of investment that is given to startups in exchange for a part of the business’s equity. The funding for this comes from wealthy investors and is managed by venture capital firms through venture capitalists.
Typically, the capital from the various venture capitalists is pooled together to form venture capital funds, which are then utilized to fund different startups and high-growth companies in the firm’s portfolio. One interesting feature of venture capital is that venture capitalists invest not only in terms of cash but also in terms of mentoring young startups.
Ideally, venture capital firms stay with a business for 8–10 years before deciding to make it public or selling off their shares and moving on. Their mantra is: Invest, Grow, Profits. You can learn more about venture capital firms, their processes, exit strategies, and more in our latest extensive blog post, “What is venture capital and how does it work.“
What is private equity, and how does it work?
Private equity is a type of investment in which private equity firms invest in companies that are either fully private, or gain control over public firms with the sole aim of making them private and delisting them. In short, they engage in leveraged buyouts (LBOs) of non-performing private and public companies who has a potential to be next Google or Facebook, but are still not there yet.
Private equity fund is also pooled money, which means it has been invested by institutional investors like pension funds, hedge funds and insurance companies, as well as family offices and high-net-worth individuals.
Usually, private equity firms take over companies that are going through financial stress and inefficient management. They then make changes in the company’s structure, bring in new talent, implement new strategies, and try to make the company profitable again and eventually selling them back at a profitable margin. They follow the mantra: Buy, Change, Sell.
Apart from this, private equity firms also provide growth capital to private companies at a minority stake. Commonly known as expansion investment, this capital investment is provided to mature companies who wants to undergo restructuring or explore new market with out loosing control of the business.
Key differences between venture capital and private equity
Venture capital and private equity are different in more than one way. Here are some of the key points that may help you understand:
Whom do they fund?
Venture capital firms are known to fund early stage companies with high growth potential. More often than not, these include businesses dealing in SaaS, Web 3.0, FinTech, Ed Tech, Consumer Tech, etc. Some of the latest trailblazers in the Indian startup world are backed by VC firms.
On the other hand, private equity firms are generally open to investing in companies across industries. Be it healthcare or food and beverages, pe firms are open to investing in any business that is in dire need of a takeover and a makeover.
What stage do they fund?
VC firms prefer to invest in early stage, high-growth potential startups that are just taking off. At times, this even means they start funding from the seed rounds (Micro Venture Capitalists) and stay for up to 8-10 years. You can read more on how to get seed funding for your startup in this blog.
On the other hand, private equity firms mostly invest in public companies that have reached maturity and are going downhill due to poor management. They swoop in, intending to revive the company and see new profits.
What percentage of equity do they take?
Ideally, VC firms look to have one portion of the business’s equity, typically 50% or less. The rest is shared with founders, angel investors, and other venture capitalists or private investors involved in the business.
On the other hand, private equity firms tend to keep the majority stake in a business, if not 100%. This is done in order to gain autonomy and decision-making power over the business.
What is the appetite for risk like?
Both VC firms and private equity firms are known to be high risk-takers. However, the difference lies in the kind of risk they are willing to take.
Venture capitalists are considered huge risk-takers as they invest in businesses from their initial stage with no guarantee of the business becoming profitable. Their investments are usually said to be in high-potential, high-risk startups. This is why they invest only in a certain percentage of the businesses in their portfolio to ensure no loss would be too fatal.
Private equity firms typically makes capital investment in mature businesses that have proof of profit in their past. Investing in these private or public firms (listed on stock exchange) ensures almost zero probability of the business failing. However, the risk factor makes an appearance in the sense that they invest in a significant share of the company.
What is the typical deal size?
The ultimate question anyone looking for funding would have is “How much would they be willing to fund?”
VC firms typically tend to invest anywhere from a few million dollars to USD 25 million. This is in proportion to the percentage of shares they will be getting from a business.
Per research by Pitchbook, 25% of private equity investments in the U.S. are between $25 million and $100 million. This holds true for a majority of the countries.
When compared, we can safely say that private equity firms investment size is a lot more than venture capital firms.
What is their ROI?
When everything is said and done, the ultimate aim of either of the investors is to make profits.
The profits of VC firms depend heavily on the performance of the businesses they invest in. If they have invested in an idea that is irrelevant to the current market scenario, the chances of them making profits are thin. Per research by a Harvard professor, 75% of venture-backed businesses are never able to return cash to investors.
PE firms, in comparison, make profits from all sorts of companies— even the ones that aren’t well known. That is, while VC firms usually make money only from the top-performing companies in their portfolio, private equity firms can make money from the companies they invest in, irrespective of their popularity.
Both VC firm and private equity investors expect high returns from their investments.
What is their level of involvement?
Venture capital funds do not just invest capital but also bring in their expertise in terms of mentoring and building strategies for young startups during their early stages of growth. VCs are usually a part of the board and have a say in the firm’s decision-making. However, it ends there. The final decision-making power lies in the hands of the founders of the business. Sometimes, the business owners choose to have the venture capitalists have more power depending on their relationship with them.
On the other hand, private equity firms have complete autonomy over the businesses they take over. This means, they have the final say in any matter and will be fully involved in the business’s operations.
What are the common exit strategies?
The ultimate aim of both types of investors is to make a profit. Once they realize the favorable profit, they will then look to exit opportunities.
The standard exit strategies for VC firms include making the firm public (IPO- initial public offering), getting acquired by a bigger firm or merging with another business (strategic mergers), selling off their shares to other venture capitalists in a secondary market, and selling off the shares to the business’s owners.
The typical exit opportunities for PE firms are a trade sale, where the company is sold to another PE firm or a secondary buyout for a medium or large portfolio company. Private equity firms also tend to exit by making the business public again once it reaches the desired performance levels.
In both cases, VC firms and private investors make profit as the valuation of company grows.
Here is a quick takeaway to understand the differences between venture capital and private equity:
|Differentiator||Venture Capital||Private Equity|
|Investee||SaaS, Web 3.0, FinTech, EdTech, Consumer Tech||Sector agnostic|
|Stage of funding||Early stage, pre-profitability||Mid to later stage, profitable, cash flow|
|Investment size||A few million to tens of millions||Wide range: a few million to billions|
|Equity percentage||Upto 50%||100% / Maximum|
|Risk appetite||High risk, moderate chance of losing all money||Moderate risk, low chance of losing all money|
|Potential ROI||Highly dependent on the investee’s performance (High chances of failure)||Will almost always see profits (since the firm is already well-established)|
|Level of involvement||Moderate involvement at owner’s discretion||Highly involved in company operations|
|Exit strategies||IPO, Acquisition, Share buyout, Sale in the secondary market||IPO, Trade sale, Secondary buyout|
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