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Home Business Loans Private Equity Vs. Venture Capital: Clarifying Blurring Lines
Private equity (PE) is often tangled with venture capital (VC) because they both invest in companies and use a variety of exit strategies, such as selling their stake during IPOs. However, there are some significant differences in the way they do business. Both invest in different types and sizes of companies, spend different amounts and even claim different percentages of equity.
Let’s have a closer look at the core differences between PE and VC firms, and try to characterize the variables that are pushing them to adopt one another’s strategy.
Private equity is a form of investment that is much more hands-on than a venture capital investment. Instead of investing to own a stake in the company, a private equity firm acquires the entire company in the form of a buyout.
Usually, the company in question is facing some type of difficulty or is distressed in some way. The PE firm evaluates the company and has a plan for how to resurrect it and make it more valuable. There’s also usually an exit strategy in mind to sell the company within a few years in order for the PE firm to turn a profit.
Who funds these private equity deals? In most cases, the answer is institutional or accredited investors. This includes investors such as:
Private equity funding can be packaged in a few different ways. The most common types of deals are buyouts, secondary buyouts, and carve-outs. Here’s what each of these means.
This is the most well-known of private equity deals. A PE firm acquires an entire company to gain complete control of major decisions. The strategy can be used on private, public, or closely held companies.
With a secondary buyout, a PE firm buys a company from another private equity group instead. The reasoning may be to fix a distressed company or to acquire a company to work with other relevant companies owned by the purchasing PE firm.
Instead of purchasing an entire company, a carve-out allows a PE firm to purchase a certain division of a company. It usually does not involve the parent company’s core operations.
A venture capital (VC) investment is a type of private equity, but instead of focusing on established companies, investors typically pick startups with the potential for major growth. VC investors can include individuals, investment banks, incubator programs, other types of financial institutions, and corporations.
In exchange for an investment, venture capitalists typically gain ownership of a percentage of the business. When profits are distributed or the company is sold, the investor gets that percentage of the total.
For example, if a VC investor invests $250,000 for 15% equity, then the startup gets acquired five years later for $10 million, the investor’s 15% stake will result in a $1.5-million payout.
There are usually two types of investments venture capitalists make in startups: an initial seed round of funding or a range of series funding as the company becomes more established.
This is typically the first round of formal investment for startups. Some may have had a pre-seed funding round, which usually just raises capital from the founder’s family and friends. In the seed round, the startup is still at an early stage, but has a concept and early proof of concept to entice VC investors.
As the startup becomes more established, it may opt to engage in additional rounds of funding. Each round is given a new title in succession: series A, B, C, D, and even E funding. Typically the company raises more money in each round.
Private equity firms buy established, inefficient companies, take total control, and make them more efficient to escalate revenue. They also attempt to capitalize on mispriced assets.
Venture capital firms, on the other hand, purchase only 50% or smaller stakes in startup companies that they believe have the greatest growth potential.
While PE firms invest in a specific company and concentrate their expertise on a particular sector, VC firms like to diversify and reduce their risk profile. Usually, VC firms are limited to technology, biotechnology, and clean air companies. VC firms also often limit their investment to $10 million in each company. PE firms are open to how much they invest, particularly since they’re usually buying out an entire company.
The core difference between the two is where they put their money. PEs invest in established businesses while VEs invest in startup growth.
VC firms understand that most of the companies they invest in will not be profitable. But they expect that at least one of them will turn in huge profits and make the fund profitable. Because startups can be so unpredictable, they basically hedge their bets across multiple investments.
Fred Wilson, a $1-billion, New York-based VC fund, expects that out of the 25 growth companies it has invested in, about 10 will fail, one will turn extraordinary profits, about five will give solid returns, and the rest will be wiped out.
Another key difference between VC and PE? VC firms use only equity to finance their purchases, but private equity investors use both equity and debt.
Additionally, PE firms have concentrated exposure in one or a few particular industries, so they have to bear additional risk. Their holdings in the companies are so extensive that, if one of the companies failed, the fund would mostly fail. However, shouldn’t higher risk translate to higher returns?
Modern portfolio theory proposes that greater risk is compensated with higher returns, but here, VC firms, even with the higher risk, are targeting the same returns as PE firms, and actual returns for both, are also very similar.
Small business owners who want to retain full ownership of their companies will most likely want to avoid outside investment.
Instead, apply for a small business loan to get the exact amount of financing you need without having to give up equity in your company.
Applying is free and won’t impact your credit.
Lauren Ward is a personal finance and tech writer with a passion to help consumers make smart financial decisions. Her work has appeared in a variety of publications, including Time and MSN. When she's not writing, she loves gardening and playing board games with her family.
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