Which one is the best source of funding for companies when it comes to Private equity vs Venture capital? Which one should you choose for your company? This guide helps us differentiate and understand these two funding firms.
Companies use different ways to raise money. And some of the most common ways are through Private Equity and Venture Capital firms.
The truth is these two are firms designed to invest in companies that need funding, especially startups. In other words, they are investors who invest in private companies, targeting future profits. Once they invest, they are offered a part of the company's ownership through shares, which they can also sell later at a profit.
Essentially, Private Equity and Venture Capital firms invest in various companies that vary in terms of short or long-term goals. And while most people will use these terms interchangeably, they are quite different, especially in how they operate. Understanding these differences will help you choose the best kind of funding for your company.
So, where do we draw the line between Private Equity vs Venture Capital firms? Let us dive all in…
Private Equity vs Venture Capital: Top Differences
To better understand these two types of companies funding options, we must first understand what each of them stands for. Therefore, let us start with the basics.
What Is Private Equity?
Private Equity is the investing of money in private companies by investors or firms. Private Equity works through a process called “Private placement,” which involves purchasing securities from an individual company that is not listed on any public markets. They can also buy shares or offer equity to public companies, but with the intention of delisting these companies from public stock exchanges.
Private Equity encompasses many different types of investments and investment strategies. For instance, a Private Equity firm does not focus exclusively on early-stage startups but rather more on companies that are already established and making profits. These will include mid-sized businesses or mature startup companies.
Private Equities generally seek to purchase stakes in these companies, providing them with capital to expand their operations. In return, they gain ownership over a portion of the company's shares.
One important thing you should note about Private Equity is that once the firm makes that investment, it will mostly take an active role in that company's management. In other words, they have a controlling interest in the company.
In addition, the money that Private Equity firms use is pooled from its investors (usually high-net-worth people, endowments, insurance companies, or pension funds. The firm is thus making the investment on behalf of the investors.
Lastly, Private Equity firms are more inclined towards long-term investments. They focus on assets that need a bit of time to sell. For example, their investments will have a 10-year time horizon or more.
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What is Venture Capital?
Venture capital is essentially the start-up capital given to small businesses and start-ups. Venture capital firms offer a helping hand to start-up companies or businesses that will usually not access other sources of funding (like banks or public markets), due to the size of the company, inadequate assets, or the company's stage of development. As such, many startups or small businesses see Venture capital as their last resort in making their businesses kick-start or succeed.
Usually, venture capital firms will consider investing in companies that show growth potential. This is quite obvious as they are risking their money to support a company that is just starting or that hasn't made big strides in the industry. They are usually driven by innovation or the potential of establishing a new niche.
Venture capital funding will mostly come from high-net-worth investors, specialized VC funds, or investment banks. And besides financial support, Vuntire capital firms also offer managerial or technical expertise to the companies they invest in.
Key Differences between Private Equity and Venture Capital
1. Company's Development Stage
This is the first and undoubtedly a major difference when looking at Private equity vs Venture capital financing options. For starters, Private equity firms focus on established companies or those in the late stages of development. In comparison, Venture capital firms focus on those start-up businesses in their earliest development stages or small businesses that are trying to establish themselves in the industry.
Private equity firms fund companies that have been in operation for at least five years, those that have proven themselves to be worth investing in. As for Venture capital ones, they can fund companies with over five years in operations or those just seeking to start up.
2. Ownership Size
Another significant difference between these two types of funding is the number of shares they buy in the company. Private equity firms generally own more shares in the company, as opposed to Venture capital firms.
For example, Private equities can buy as much as 100% of the company's shares. This means that they will have full control of the company they have invested in. However, in most cases, they will buy 51% of the shares, meaning they become the major shareholders.
In contrast, Venture capital financing will mostly buy up to 50% of the company's share. They prefer to invest in different companies (start-ups) rather than risk all their money in one venture. This means that Venture capital firms take a minority share of the company's ownership.
3. Risk Level
Another important component that differentiates Private equity vs venture capital investments is their risk level. Private equity investments are generally less risky because they focus on mature companies or businesses.
In comparison, Venture capital investments are much riskier since they involve investing in start-ups or small businesses with a high possibility of failure. However, while Private equity investments are less riskier, their returns are also not as high since the growth potential of the companies they invest in is not quite high.
However, Venture capital investments might have better returns since they focus on companies with high growth potential. So, if the start-ups succeed, the returns will be quite attractive. As the saying goes, “the higher the risk, the better the returns.”
4. Tools of Investment
These two investment firms use different ways of offering capital to the interested company. For the Private equity ones, leveraged buyouts are usually the main tool. This involves using a combination of borrowed funds and equity to buy the company's shares.
Since the company will have to repay this debt, the PE firm will work hard to ensure that the company is profitable. This helps to ensure that the loan doesn't become a burden to the new company.
VC firms, on the other hand, get most of their funding money from equity. And while they might also use debt to buy shares in the fledging company, it usually occurs in the later stages of the investment process.
5. Equity Stake or Investment Size
As mentioned earlier, Private equities look for the majority share in the company they invest in. For this reason, they tend to invest or stake more money, usually upward of $100 million. We can say that PE firms prefer focusing their money and efforts on one company and helping it work for their benefit.
Venture capital funds work differently. They invest sizeable, but not so high, amounts of money in various companies, thus diversifying their portfolio and reducing risk. Usually, VC firms will stake around $10 million in a company or less, as they are aware that start-ups have higher chances of failing just as they can succeed.
6. Scope of Purchase
While both are sources of funding for private companies, they have different scopes of purchase. Private equity firms usually have a wider scope, funding companies from almost any industry.
On the other hand, VC firms are only allowed to fund start-ups and businesses focusing it technology, clean technology, or biotechnology. An excellent example of a VC firm is Google Ventures. Some of the fund's portfolio companies include Uber, 23 and Me, and Stripe.
See Related: Private Equity Firms Ready For Higher Pursuits
Similarities between Venture Capital Firms and Private Equity Firms
Even with these obvious differences, you also find several similarities between a Private equity and a Venture capital firm.
- They both have the same structure – a limited partnership structure. This means that each is made of several partners who contribute to the fund. Some partners have active roles in managing the fund, while others are just investors who contribute money.
- Both PE and VCs use accredited investors as their source of funds. This means that investors who pool money in these firms must have a net worth of $1,000,000 or a yearly income of not less than $200,000.
- They have the same goal, which is to grow the value of the companies they invest in, in anticipation of higher returns later.
- Both of these firms invest in private companies that have difficulties raising capital through other traditional means.
- Both PE and VC firms acquire shares of the company in exchange for funding. They both become part of the company's ownership.
These similarities show a clear reason why so many people might mistake or use the names interchangeably.
Pros of a Private Equity Firm
The first advantage of taking financing from a private equity fund is that it offers more than financial assistance. With this fund, you will also receive personal expertise from the private investor. This is because the firm becomes part of the new company's management, with the aim of making it better and increasing its profits.
Additionally, PEs offer quite a considerable amount of funding, even up to $100 million or more. This gives the company a better chance of succeeding since Private equity funds provide the capital needed to expand and grow.
Cons of Private Equity
Private equity investors acquire the largest part of the company. In other words, they are the main shareholders. What this means is that they have control over what the company does or what it doesn't.
The investor can sack employees and the executive or even sell the company when they deem it fit. Remember, the investor is here to make money. As such, they might make any decision that helps them do just that.
Consequently, this means that the owner of the company has no control over what happens in the company. They lose control of the company after the buyout.
Advantages of a Venture Capital Firm
Venture capitalists are quite instrumental in the success of most start-ups and small businesses. They offer the funding necessary to kick-start the business or improve the company's growth.
Also, just like PE investors, VC investors can offer their expertise and knowledge to help the company grow. This helps in increasing their chances of making profits in the future. It also helps avoid mistakes that many startups commit and minimize the risk of loss.
Lastly, VC firms are usually more connected. This means that they can easily help the new company to find and explore new growth opportunities. As such, they are instrumental in helping the company grow.
Cons of Venture Capital
Just like Private equity, Venture capital takes part of the company's ownership. This is because you relinquish some of the company's shares in exchange for the funding.
The more funding you need, the more shares you'll have to give away. Therefore, you will lose significant control of your company.
FAQs
What is Private equity investment?
Private equity investment refers to the financing of private companies, usually through acquisition or expansion. Private equity firms typically provide capital by purchasing a majority stake in the company, and they often bring their expertise in management and operations to help the business succeed.
What is venture capital?
Venture capital is a type of funding that is typically provided to early-stage start-ups and small businesses. Venture capitalists provide the capital needed to get these businesses up and running. Like a Private equity investor, a VC firm also offers its expertise in management to help them grow and succeed. From here, these businesses can qualify for investment banking loans or private equity.
How much capital do Venture capitalists offer?
The amount of capital that a venture capitalist offers can vary widely, depending on the size and needs of the business seeking funding. However, they typically offer between $1 million and $10 million.