You will find many articles/blogs on this topic, covering definitions and processes but in this article I am going to elaborate on what these funds actually into while exploring a business and which business they prefer to invest in.
Being associated with a venture firm for over a year, I have seen many businesses grow but not all are eligible for investment either (whether that is from a venture fund or private equity or both).
Let’s cover what these funds are: Private Equity is a pooled fund created by raising funds from institutional investors. It is then invested into various equity and/or debt instruments depending on the fund policy and requirements. On the other hand, Venture Capital is a form of PE that also raises capital from institutional investors – but this fund only invests in equity of early-stage companies or startups.
Both funds raise capital from institutional investors known as limited partners in legal terms and the firm distributes profits after earning return.
Both funds aim to increase the value of the business they invest in and make an exit by selling the stake to the public or in an acquisition.
Both funds invest at different stages of a business life cycle. Venture Capital invests at an early stage of the business to boost the business and penetrate the market whereas Private Equity comes in at maturity stage for expansion or at decline stage as distress financing.
Private Equity usually invests high capital and acquires a majority stake of the business while Venture Capital invests in small chunks and takes less equity stake in the business.
Venture capital firms face high risk as they invest in early stage of the business thus, they require high return/equity stake in the business. Alternatively, Private Equity comes in the later stages and knows the market and business thus, they face less risk but due to high investment capital they too take away 40-70% stake.
Venture Capital firms invest in early and growth stage businesses and inject capital at various rounds of fund raising by the business. The Venture Capital firm can’t do much due diligence at the early stage of the business because of less historical data available, and sometimes it is unclear what the market itself is until operations begin.
It is presumed that Venture Capital is for technology startups which can be true because of the high risk involved. Investors are looking for high return, and technology is something that can bring exponential growth to a business.
Here are some things VC’s consider before investing:
- How good the product is and what problem is this product solving that can serve a wider community in the future.
- Can the business grow exponentially, especially the gross revenue?
- How good and committed the management is with their business.
Private Equity firms invest at a later stage, like mature or decline phase companies that require capital either for expansion or to bailout the distressed business by providing equity, debt or mixed capital. In Private Equity, due diligence is very extensive because of the selection criteria of investment.
Here are some things PE firms look at before investing:
- What are future business prospects if the business expands to another market or how quickly the distressed business can regain the market share or turn into positive cashflow?
- Private equity firms invest in any type of business that has good potential to earn a return for the firm.
- Need to have positive cash flow in the expansion equity investment case.
- Private equity invests in real estate projects and in other funds of funds too for steady dividend income.
Aforementioned that Venture Capital firms invest at an early stage of business, so they asked for a higher stake of equity relative to investment amount than PE. Here the investors know how much they are going to invest but the equity stake is formally negotiated with both parties and most of the time at early-stage businesses instead of shareholding agreement parties sign simple agreements for future equity commonly known as SAFE’s.
Depending on agreed terms venture capital firms do take board seats but can participate in reserved matters and do not participate in the business operational strategy.
These deals are more complex than VC deals because of heavy investment and various types of investment i.e equity and debt mix (leverage buyout).
Depending on the fund strategy, some investment deals require share of business profits as well as equity growth. This mostly happens when private equity acquires a majority stake in the business and or invest in real estate businesses. Even for expansion or for distress financing firms require just not a board seat but take part in business and operational strategy.
Hope this helped clear any confusion you have between the two. If you found it helpful, share it with your friends!