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Capital Formation Strategies: Understanding the Difference Between Venture Capital and Private Equity

by | Dec 9, 2020 | Private Equity

For companies and entrepreneurs looking into raising capital, the terms used to delineate classes of investors can be confusing—particularly when they are misused or misunderstood by the media or the public at large.

For example, private equity and venture capital are sometimes conflated. This is a mistake: Private equity and venture capital – though related – are distinct types of investments. And knowing the difference between the two is critical for enterprises developing their capital formation strategies.

To help clear up potential misconceptions about venture capital and private equity, let’s explore the difference between the two investor categories when raising capital.

VENTURE CAPITAL

Venture capital (VC) firms primarily focus on investments in early-stage, pre-public companies. In general, the money they provide helps businesses advance through the first years of the corporate lifecycle.

Venture investments can require many years to pay out, and a VC firm must have a tolerance for substantial risk – after all, an untested start-up company’s products or ideas may fail.

The hope, of course, is that the company will either achieve a successful stock offering or be acquired by a larger company that allows the VC fund to exit with a strong return on its capital. One of the most famous recent examples of a VC home run is Sequoia Capital’s investment in WhatsApp. The California-based venture fund was the sole venture investor in the company, putting in $60 million during the technology start-up’s two funding rounds. When Facebook acquired the company for $22 billion in 2014 – the largest-ever purchase of a VC-backed company – Sequoia made more than $3 billion, according to published reports.

Most venture investments, however, are far smaller ($1-$10 million or less). Multiple investors, rather than a single backer, are often involved, which generally results in venture funds taking a minority stake in a company (less than 50%). The smaller investment amounts also allow venture funds to invest in several companies at once. To help boost their chances of success, they sometimes require seats on boards of directors of the companies in which they invest, to assert greater control over the direction of the enterprise.

By spreading investments and taking board seats, the VC fund is better able to absorb losses and reduce the risk for its investors. VC funds are generally backed by “limited partners,” such as wealthy individuals and institutional investors (like pension funds or charitable endowments). The managers of the firm, or “general partners,” tend to have investments in the funds as well, which provides investors some comfort as their interests are more aligned with the general partners.

In addition, venture capitalists tend to focus their investments on companies that are likely to grow quickly. Fast growth can be far more important to a VC fund than profitability or the long-term stability of a company. A fast-growth start-up may allow the fund to exit more quickly and earn a higher multiple on its investment than a company with a slower, but steadier, trajectory.

PRIVATE EQUITY

Private equity (PE) funds are structured similarly to VC funds, with limited and general partners pooling resources to make a return. Private equity, however, refers to investors who focus on more mature companies that can be acquired and resold for a substantial return. Unlike venture capital investors, private equity firms generally purchase whole companies for larger sums and often utilize debt-based financing (such as leveraged buyouts) rather than a cash-based approach to make their investments, which allows private equity firms to maximize their returns and potentially increase the number of acquisitions they can make.

Private equity tends to be less risky than venture capital because investments are being made in companies that are already established. Thus, the chance of losing all of the money invested is minimal. While VC firms usually focus on sectors where fast growth is more likely (such as technology), private equity investments target every industry.

The companies private equity firms acquire may need infusions of capital and significant reorganization to boost profitability. Throughout the time a private equity firm is invested in a company, they may use their expertise to make changes to the management of a company, its strategy, and spending in an effort to make the company more profitable and therefore more attractive to potential buyers.

A higher profit margin benefits PE firms during their ownership of the company by allowing them to utilize the capital in several ways including paying off debt, making operational improvements to the target company and provide returns to investors. When they are ready to exit, higher profit margins also would likely allow them to generate a significant premium on their equity.

Typically, a private equity investor holds on to its investment for a few years before flipping the company for a profit. However, this strategy can vary depending on the investment profile of the PE investor, economic conditions, and growth curve for a particular industry sector when raising capital. PE firms have been known to retain their investments for decades if they are receiving a strong cash return from a mature, well-run company.

Having a basic understanding of the differences between venture capital and private equity is merely the first step for companies interested in raising capital. To learn more about capital formation and the legal complexities involved in venture and private equity funding, contact us for a consultation.