Private Equity vs Venture Capital

In this article, we discuss private equity vs venture capital focusing on their operating similarities and differences.

Private investment markets are a thriving business today. The numerous options and flexibility available for investors and entrepreneurs alike have made private markets the most sought after investment zone. Private equity and venture capital are among the most profitable ones. In this article, we discuss private equity vs venture capital focusing on their operating similarities and differences.

Private Equity vs Venture Capital

There are two types of investment markets – private and public. Public equity is available for everyone, firms, and individuals alike. Market risks with public equity are comparatively lower as every publicly trading company is first and foremost accountable to their equity holders. But private markets follow a format of high-risk, high-return. Public equity solely focuses on profits. While private equity additionally plays a nurturing role for companies in trouble. Private equity funds and venture capital are subsets of the private market. Let’s discuss each one further.

What is private equity and how they work?

Private equity funds are created by pooling huge amounts of money from high net worth individuals who are accredited investors, or large institutions such as pension funds and other private equity firms. These funds are used to buy shares in established private companies or public companies to make them private by de-listing them from the stock exchange.

Private equity funds identify companies that have stagnated or particular business units that are not performing to their full potential. By investing in these pockets, they take over the company during the investment horizon which lasts between two to six years. During this time, PE firms use their invested money and the expertise of all investors on board to identify weaknesses in the business structure, re-strategize, and take the necessary actions to steer the company towards exponential growth.

By the time of exit, when the private equity funded business is yielding massive profits, PE firms sell their shares for high returns. These firms charge their investors about 20% of the profits made at each exit and 2% as a performance fee for all the assets under their management. Investors are flooding the private equity market owing to the high rate of returns compared to traditional investments in shares and bonds of public markets.

Some of the top private equity funded companies included Ant group, Cerebral, Uber Freight, Zero Grocery and Hyperice. While the top private equity firms consist of The Blackstone group Inc, Neuberger Berman Group LLC, Apollo Global Management Inc, The Carlyle Group Inc and KKR & Co. Inc.

Pros and Cons of Private Equity

Private equity funds are definitely a lucrative option for any business owner, especially startups. But like all ideas and opportunities, these have their hits and misses as well. Here are some of the pros and cons of private equity funds

Pros of private equity:

  • Attractive alternative: Growing businesses usually raise operating capital from banks and other financial institutions. This money comes with time-bound contracts and heavy interest rates that become a burden for growing companies. Private equity does not impose any of these.
  • Both parties win: With private equity, both investors as well as receiving companies benefit from this arrangement. Investors get massive ROIs within a short time while companies raise large operating capital with lesser conditions and liabilities.
  • Money & Expertise: Private equity investors are usually experts in their respective fields. They not only invest money but also share their skills, experience, and industry knowledge. Thus, private equity funds become a great opportunity for mentorship to the grantee company as well.
  • Flexibility: Private equity is a form of partnership. Companies can choose who to receive funds from and whom to deny. Companies are free to choose those private equity investors whose goals and aspirations align with their vision for the company.
  • Quick & No obligations: The process of private equity fund raising is focused and much quicker than the regular processes of banks and other traditional funding institutions. Besides, companies are not obligated to return the funds to PE investors.

Cons of private quity:

  • Shared control: Private equity investors automatically become part of company management. They have a controlling position in all management decisions. This could be an interference at times.
  • Dilution: Every private equity funding round dilutes the shares of existing stakeholders. In the initial stages, every round shaves off stakes from founders. As the company expands, dilution is inevitable for all existing investors already on board.
  • Highly competitive: Private equity funds are still a growing market. Comparatively, there are less investors, and competition is severe. Data shows that only 1- 3% of applications are accepted for investments. Securing PE investors could then be a tough task.
  • Formality: It is true that companies do not have to repay the money to private equity investors. However, the money is granted with many strings attached. Since investors become a part of the company management, there is constant pressure to perform and generate profits. Founders must follow a formal method of reporting as well. This could become an imposition for a growing business.

What is a venture capital and how do they work?

Venture capital funds, on the other hand, invest in startups in exchange for a percentage of equity. VCs, take the position as a board member as opposed to PE investors who take over the complete ownership of a company. VC investors are seasoned entrepreneurs with vast business experience that becomes an important resource for any growing business. Apart from funding a growing business, venture capital plays a crucial role in mentoring a startup.

Venture capital funds are granted through funding rounds. These rounds are based on the stages of growth in the life cycle of a business. The initial one is the seed round (focused to develop a prototype) which is mostly funded by Angels, but if the business idea shows promise, micro VC funding might be granted. Following this is Series A (to establish a workable business plan, scale-up distribution, launch in new regional markets), Series B (focused on new acquisitions, globalization, team expansion), and Series C (where an established business considers acquiring new IPO or new businesses).

Compared to private equity funds that are granted in bulk, venture capital funding takes a progressive route. Ideally, the funding amount must increase with every consecutive round. VC investors analyze the company’s previous performance and commitment to benchmarks before granting the next round. An exponential increase in VC funding with every round adds to the credit of the company. Unlike PE that is driven by the investors, VC funds are managed and driven by the company management with expert guidance from the investor as a board member.

Some of the top VC funded firms include WeWork, Airbnb, Slack, Palantir Technologies and Juul. While the top VC firms consist of Accel, Andreessen Horowitz, Benchmark, Index Ventures and Sequoia Capital.

Pros and cons of venture capital

A venture capital fund is a boon for a growing startup. This funding mechanism is designed to catapult a startup to the next stage. But if not prepared, it can soon turn into a liability. Here are some pros and cons of this funding mechanism.

Pros of Venture Capital:

  • Supports accelerated growth: Venture capital funding provides startups with the much-needed capital in the initial stages of expansion. This is a time when money is consumed as fuel for the growth spurt. Delay in funds at this stage can heavily cost a startup’s success.
  • No repayment: VC investors do not expect their money to be returned with interest, like a bank loan. On the contrary, they are expecting massive ROI from their investments in a startup in comparison to other market investments. If the business fails, they absorb the risk.
  • Resource sharing: Venture capitalists bring in years of expertise and important contacts such as legal, tax, and media. These contributions are of immense importance for a growing startup.
  • Safe assets: It is normal for startup founders to involve their personal assets to raise funds. Thankfully, the option of a venture capital fund protects them from undertaking any such liabilities.

Cons of Venture Capital:

  • Loss of autonomy: Similar to private equity, venture capitalists take a position of a board member till the exit. They become a party to all strategic decisions of the company. Startup founders in this case lose autonomy over company decisions which might be a problem in the early stages of a business.
  • Heavy accountability: VCs often assume the role of mentors to startup founders. Considering the years of industry experience they bring, it is in a way an advantage. But founders become heavily accountable to them. They must follow a formal process of reporting. They are constantly expected to be answerable to VC board members.
  • Long process: VCs are ultimately in this funding game for massive profits. Since they fund startups in their early stages, the onus of market research and analysis to judge a startup’s profit potential lies on them. Thus they undertake thorough quality checks before investing in a company and this takes a long time.
  • Highly competitive: Similar to private equity, the Venture capital fund market is small compared to the flurry of mushrooming startups. A founder must either be part of startup accelerator programs to get direct access to VCs or must nurture a strong network to source the right introductions.

Why are Private markets becoming more attractive?

Initially, every company began in private mode with private funding. Gradually they expanded to reach a point where private funding could no longer support their growth. At this point, private companies went public and used all the fresh inflow of capital from public shareholders to scale up their business. Despite the heavy regulations and periodic reporting requirements, companies stayed public as the private markets could not support their financial needs.

But over the years this scenario has changed. In the US, private markets today form close to one-quarter of the economy in terms of capital while 98% of the companies are funded by private equity funds. This shift happened primarily because :

  • Increase in private investors – Private equity funds hold the promise of a higher rate of return. Thus private investors are drawn to the potential of massive profits. This increased influx of private investors has made it easier for companies. They are no longer compelled to go public to raise the required funds.
  • Increase in the capital – As more private investors entered the market, more funds became available for companies showing a promising profit potential. With the availability of venture capital, more startups found the courage to enter the market and explore their business ideas. Similarly, companies in trouble started seeking private equity funds to bail them out of their troubles.
Thus private markets are thriving by the day, creating a dynamic stream of innovative business concepts backed by the funding required to see them through. Going public is no longer a compulsion. Also, owing to the high-risk profile of private investments, precise metrics are being used to minimize monetary losses.

Private Equity vs Venture Capital

Both private equity and venture capital are popular investment instruments of the private market. Despite their similarities, they differ in fundamental ways of working. Let’s take a look at how they vary from each other and the common threads that tie them under the private market.

What are some major differences between private equity and venture capital?

Private equity and venture capital differ in the following aspects:

  • Company of investment – Private equity funds are focused on established companies that are failing in certain business units or being inefficient to use their resources for profit. While venture capital chooses early-stage startups that need funds for their basic growth, product development, and expansion to new geographies.
  • Amount of investment capital – Private equity firms concentrate on one company at a time. These investments are in the range of $100 million, as that is the range of funds required to pull up mature companies from a slump. Meanwhile, venture capital funds are on an average of around $10 million per company. These firms invest in multiple startups at a time and mentor them all through the process.
  • Equity claim – Private equity funds by design claim almost 100% ownership of the investing company. This is also known as a buyout. This autonomy gives them the freedom to run the business as their own and ensure massive returns over time. Meanwhile, venture capital usually claims less than 50% of each company. This entails partial control yet participation in the decision-making process of the company as a board member. Startup entrepreneurs only share their vision with the VC investor.
  • Risk – Private equity funds can choose any type of company, across industries and use both cash and debt. Since they invest in mature companies, the level of risk is low. While venture capital is focused on startups, mostly the ones promising technological advancements. The basic criteria however are to choose companies that have a functional business plan in place. Thus the risk, though high, minimizes the chances of losing all the money.

What Are Some Similarities between Private Equity and Venture Capital?

Both private equity and venture capital are private market instruments. They are similar in the following ways:

  • Mode of operation – Both private equity funds and venture capital pool wealth from HNIs (High net-worth individual) and lending institutions. A dedicated team of professionals works at sourcing, analysis, acquisition, and execution of these funds with the sole aim of drawing massive profits over a short time. Both PE and VC firms are structured to have Limited Partners (LP) who invest and General Partners (GP) who are responsible to manage the funds.
  • Earnings – PE and VC firms charge a percentage of the profits made, usually 20% of every deal. Also, an additional performance fee is charged on all the assets under the management of the firm. This value is usually around 2%.

Private Equity (PE) vs Angel/Seed

Apart from private equity and venture capital, there is another category of private investors known as Angels or seed investors. Angel or seed funds are targeted at early-stage startups. Though private investors engage in these funds, they differ from private equity in quite a few ways. Let’s take a look at some basic aspects where Angel and seed funds are different from private equity funds.

What are some major differences between private equity and angel or seed?

Private equity and angel and seed funds vary in the following basic aspects:

  • Angels and seed investors are mostly HNIs with immense business experience. They usually operate on their own and apart from wanting to make profits, they are inclined towards mentoring early-stage startup entrepreneurs. Private equity operates through a firm by unifying money from several deep-pocketed investors. The focus here is to make massive profits while re-structuring a business to its maximum profit potential.
  • Angel and seed investments are usually between $10k to $1 million. Angel investors simultaneously invest in many startups based on the merit of the business proposal. While private equity investments are in the range of $100 million. PE investors are known to focus on one company at a time.
  • Angel and seed funds are quite a high-risk investment as the startup does not have any metrics to show at this stage of operation. Company valuations of such companies heavily rely on forecasts. Also, investors rely a lot on qualitative factors such as the entrepreneur’s reputation, product idea, market fit, etc. Since private equity funds focus on established companies, investment decisions rely heavily on data from the company’s past performances, which is then used for future valuations. Also, there is a reference to hardcore metrics such as EBITDA, free cash flow, and projected IRR.

Table Comparing PE vs VC vs Angel/Seed

PE, VC, and Angel/seed funds are gold mines of the private market. Irrespective of the companies they fund, the profits generated surpasses traditional methods of investments in stock and bonds in the public market.

In the table below we have consolidated the basic differences between each of these funds. As the startup market place has grown, so has the investors’ pool. Companies are no longer compelled to go public to raise funds.

Angel/Seed fundVenture capital fundPrivate equity fund
Funds early-stage, pre-revenue startupsFunds startups in expansion mode (new team, geography, new business, IPO)Funds mature companies with smooth cash flow
Funding in exchange for equity or SAFEFunding in exchange for equity and convertible debtFunding with leverage
Investment amount $10K to a couple of millionInvestment amount couple of millions to tens of millionsInvestment amount massive in the range of a few hundred million to a few billion
High-risk funding. High chances of losing all moneyHigh-risk funding, yet chances of losing all money are moderateModerate risk and chances of losing all money are minimal
Proposals are screened based on the credibility of founders, TAM, user base, market share potential, etc. Proposals are screened based on market share, revenue, and growth rateProposals are screened based on hardcore metrics such as EBITDA, IRR,cash flow, etc.
Targets about 100x returnsTargets about 10x returnsTargets 15% IRR

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