Startup Financing: understanding venture capital vs private equity funding differences
For many startup founders, that are looking to raise startup investment capital most turn to seed (angel) or VC investors as the go-to resource. What gets talked about less often is how traditional private equity has gotten into investing in earlier stage company growth.
Private equity and venture capital are two ways business owners can shore up cash to run or grow their enterprise. I think that private equity is a less understood potential investment option for high-growth startups. A Forbes contributor Bernhard Schroeder recently wrote an article about this topic, where he posed the scenario “what if you are/were an entrepreneur whose company’s business model generated revenue out of the gate in the first month and your team was able to grow the company to $1-2 million in revenue with little debt and good cash flow? Would you really need venture capital or are you a candidate for private equity financing?”
Private Equity Investing Marketplace
After a year of pandemic-driven turbulence that suppressed fundraising and deal activity, private markets have rebounded across the board. McKinsey’s Private Markets Annual Review indicates that private equity has risen to new heights. The Forbes article mentions that “fundraising in 2021 was up by nearly 20% year over year to reach a record of almost $1.2 trillion; dealmakers were busier than ever, deploying $3.5 trillion across asset classes; and assets under management (AUM) grew to an all-time high of $9.8 trillion as of July, up from $7.4 trillion the year before.” Is private equity going to give traditional venture capital a run for its money with regard to entrepreneurs? Well it depends. Tiger Global a prominent hedge fund and private equity firm known for its big bets in companies including Coinbase and Roblox, have committed $1 billion of its own cash to invest in seed funds that focus on backing the youngest startup companies according to reporting from Bloomberg.
What is Private Equity
Private equity (PE) is a type of alternative investment in which a private equity fund and/or investors make direct investments in company shares of privately held companies that are not publicly listed. This investment capital is provided by individuals or institutional firms with a high net worth., The private equity firm brings value by infusing cash, going after bolt-on acquisitions, chase growth opportunities, restructuring debt, and providing more resources and talent. Generally, private equity firms like to take control of a private or public company. The Forbes article author mentions that sometimes this “can really scale a smaller firm looking to compete in a larger marketplace. If a solid management team is in place, the investors are traditionally more hands-off in running the company.” These organizations buy companies that are struggling or have growth potential and then try to repackage them, speed up their growth, and — theoretically — make them work better. Then, they sell them to another firm, take them public, or find some other way to offload them. There are plenty of stories of leveraged buyouts by PE firms that did not work out successfully, just read this Vox article titled “Private Equity, Explained”.
What is Venture Capital
Venture capital is an alternative financial investment asset class used to provide Series A and later rounds of funding for new startups and emerging technology companies, which is provided by wealthy individuals known as venture capitalists. Typically, several venture capitalists pool their resources, and outside investors, to form a limited partnership and they identify promising startups or emerging high-growth companies. The group will initially buy a minority equity stake in the company and use its collective funds to grow the business. Venture capitalists are more involved in the growth and management of the company with board meetings, connections, and more company oversight. Venture capitalists and venture capital funds invest in startup companies at different stages of the business life cycle. The three main types of venture capital are seed capital, early-stage capital, and late-stage capital.
Private Equity VS Venture Capital: What are the Key Differences?
Stage of company growth – Private equity firms tend to invest or buy companies with solid revenue/cash flow, or are in distress, while venture capitalists usually invest in startups and companies in the early stages of growth that have a high potential for growth.
Type of company – When you compare private equity vs venture capital, one of the major differentiators is the types of companies they each support. Private equity firms often have diverse portfolios that cover all industries, from healthcare to construction, transportation to energy. Contrary to this wide scope, venture capitalists usually have a narrow focus on technology/ Software (SAAS) or innovator companies (like biotech or clean energy).
Actual investment size – According to PitchBook, 25% of private equity deals in the U.S. are between $25M and $100M. Many venture capital deals are less than $10M in Series A rounds, though subsequent funding rounds can be much larger. PE firms tend to do larger deals than VC firms because they acquire higher percentages of companies and focus on bigger, more mature companies.
Percentage equity acquired – A key difference between private equity and venture capital is that private equity firms usually purchase a majority share or the entire company, whereas venture capitalists only get a portion. If they don’t get 100%, at the very least a private equity firm will secure the majority share, effectively claiming autonomy of the company. Most of the time, venture capitalists will receive anywhere from 10-20% equity in a “Series A” round of investment. They can gain more equity in subsequent rounds if they are needed. Although there are circumstances where a VC will take controlling interest such as when Softbank bought out most of the WeWork founder’s shares.
Risk Appetite – Venture capitalists expect that the majority of companies they back will eventually fail. However, the model works because they hedge their bets by investing small amounts in lots of companies. This strategy would never work for private equity firms. While PE firms make a relatively small number of investments, each acquisition is significantly more expensive. It only takes one company to fail and the entire fund may be impacted. PE and VC firms invest in different sizes of businesses. Private equity firms won’t touch a company that doesn’t have any sales, but a VC firm will. VC investing tends to be riskier since the company is just starting out. This is why private equity firms target more mature companies with solid revenue and cash flow, as the probability of failure is greatly reduced. But PE firms also will target distressed companies who are struggling or facing bankruptcy and do a leveraged loan takeover or buy out.
Return on investment – Both private equity firms and venture capitalists target a 20% internal rate of return (IRR). However, more often than not, they usually fall short. For venture capitalists, the return hinges on the success of just a few top companies in their portfolios. By comparison, private equity returns can come from all sorts of companies, even ones that aren’t as well-known. Both PE and VC investors bring knowledge and expertise to the equation, but PEs are looking for a quicker turnaround on their investment than a venture capitalist, who is willing to wait for the payout. Both firm types aim to earn returns above those of the public markets, but they do so differently: VC firms rely on growth and companies’ valuations increasing, while PE firms can use growth, multiple expansion, and debt pay-down and cash generation (i.e., “financial engineering”).
Operational Focus – PE firms may become more involved with companies’ operations because they have greater ownership, and it’s “on them” if something goes wrong. A private equity investment almost always comes with a change of leadership. This means that operations are also likely to be overhauled. Venture capitalist investments do not come with a change in the control of the business. While VC investors might offer compelling advice, operational overhauls are less common. Although famed VC firm Andreessen Horowitz does take an operational role in its portfolio investments it has operational teams that assist executives with recruiting, sales, and marketing.
So, as a startup founder or entrepreneur, which one is best for you? It depends on a multitude of factors, including the type of company you have, the current stage it’s at, and your business objectives. If you have the type of company that can generate revenue and cash flow quickly, you have more options to stay away from giving up equity or taking on debt early in the company’s life. If your goal is simply to make a lot of money in a short space of time, private equity might be the best choice. On the other hand, if you want to innovate or disrupt an industry and become a significant player in the marketplace, and you need strategic partners to grow your company together, you should go with venture capital. Whatever you decide, seek good advice and choose wisely. Despite these differences, a company seeking alternative investors should look for the same attributes from the private equity companies or venture capital firms they work with. That means partnering with someone who knows the business and genuinely wants to help. Of course, we suggest working with an experienced startup-focused accounting firm, like Huckabee CPA, well before your startup is in the due diligence phase of an important fundraising or m&A transaction. Feel free to contact us if have any questions or get a free consultation.