Ambitious startups are often expected to seek out different funding sources at different stages of growth. Meanwhile, various players are eagerly determining how and at what stage they will participate.
Major questions have stemmed from the ambiguity of capital sources – leaving entrepreneurs unclear on how they should approach raising money. At first glance, venture capital and private equity seem to suggest the same thing. So much so, these terms are often used interchangeably.
It’s fair to say that the distinction between venture capital and private equity funding has become somewhat blurred. Look closer and they can be told apart by their fundamental differences which ultimately determine the return on investment.
To understand the differences, one must appreciate where they overlap. Both can help to sustain and drive growth by injecting large cash sums and expertise. The differences come from the scale of investment and the methods used to drive the business forward.
Venture capital involves relatively small investments in companies emerging from the very initial stages of their development. Whilst generally sizable, these investments are relatively small compared to the large cash injections into mature companies from private equity.
(Total value of venture capital investments in Europe from 2013 – 2018. Image: Statista)
When fresh and promising concepts emerge and ideas take shape, small enterprises or startups are often unable to bootstrap their way and so turn to venture capital. Such firms provide investment and support to growing companies before they make a public offer.
As such, the capital is provided as equity capital. The financer accepts the risk to invest in early-days, yet promising companies in the hopes that it will become successful. It’s a popular source of capital in sectors requiring substantial initial capital investment, like information technology.
Simply put, private equity firms buy established companies, restructures, develops, and make them better – before selling again and hoping for a profit. Typically, such companies will not be publically traded on the stock exchange and are experiencing high growth that demands rapid and large investment.
Private equity depends on the maturity and operating history of the company and may include both equity and debt financing.
The procedure, unless otherwise agreed, is typically completed in five stages of financing.
- Seed capital: A low-level financing option to fund research and development and fructifying a new idea.
- Start-up: Finance product development and marketing.
- Early stage: Funds manufacturing, early sales and marketing.
- Expansion stage: Funding expansion to additional markets
- Pre-public stage: Bridge financing that funds the “going public” process.
The most common investment strategies in private equity include leveraged buyouts, venture capital, growth capital and mezzanine capital. The preferred strategy is determined by the maturity and success of the business.
Growth capital represents an investment in a company with proven concepts and products that are generating significant revenue. When such companies want to expand their operations, they may sell equity for capital and expertise to increase the value of their company.
Alternatively, leveraged buyouts involve very mature companies that seem to have come to a halt. Whilst they generate significant cash-flow, many find it more appealing to strike a deal that optimises their capital structure.
Private equity firms typically buy 100% ownership of the companies in which they invest. They don’t, however, maintain ownership for the long term. Rather, they prepare an exit strategy after a few years. The aim is to buy, improve and sell for a profit.
Venture capital, on the other hand, rarely exceeds 49% ownership in the investment. Due to the high level of risk, most venture capitalists prefer to invest in many different companies for less equity.
At the very core of the venture capital model of investment, investors are inherently more involved far beyond the balance sheet. This is especially true if they have been involved since the early days and provided speed-money.
Whilst their level of involvement is at the business owners discretion – venture capitalist expertise and assistance are often welcomed warmly by business owners.
On the other hand, companies have been historically wary of private equity takeovers. Some fear for their jobs and worry about the company drowning in debt. However, private equity firms, in general, usually aim to enhance and expand the companies they invest in.
They develop a more personal affiliation with the company and put effort into enhancing its development. This invariably makes their newfound asset more valuable when it comes to selling.
Risks and Returns
The risk-return ratio of venture capital is accounted for by the nature of its high-risk investment segment. The average return rate expectations of successful venture capital should be just as high as the risk.
Due to the fact that 75% of venture-backed startups fail (FastCompany), combined with market uncertainties; venture capital investments tend to be higher risk. However, This investment method often operates in high-growth multi-billion dollar industries like technology and fintech and so come with extremely high return potential.
Effective strategies and diligent decision-making should minimise risks of failure and allow for higher returns on investment. As most venture capitalists will invest in a number of companies, they are aware that many will fail. Their hope is that at least one of their investments will generate large returns and make the entire fund profitable.
Despite the high risks associated with this model, investor capitalists will only invest small amounts of money in many companies. Therefore, the risk is spread out.
On the other end of the investment spectrum, private equity firms invest in companies that have reached a high maturity level in the business life cycle. They’re well-established and operate on a strong track-record that demonstrates consistent growth and profitability.
As such, the prospect or risk is significantly less which allow for private equity deals to be larger in value. Following larger investments, one can anticipate operations to generate higher returns.
In practice, investors shouldn’t undertake more than a few private equity investments at a time. Even if a single company fails, the entire investment fund fails with it.
Venture Capital vs Private Equity: Which is Best for You?
A multitude of factors should be considered when thinking about where your capital investment should come from. From the structure of your company, the industry you’re in, the current stage it’s at and your business objectives; each should give an indication as to where you’re likely to be entertained.
If your goal first and foremost is to make a lot of money in a short period of time to expand an already successful business, private equity is the best option. On the other hand, if there are ideas you’d like to explore, wealthy business partners you’d like to forge an alliance with or simply get your business off the ground, venture capital will serve you well
These differences also highlight many ways in which the two sources of capital overlap. When seeking investment, management teams should consider all avenues to ensure they find the best fit for their business.