If you are looking to invest in a start-up or you are a start-up founder trying to secure investment, it’s essential that you understand the difference between private equity and venture capital. Both are forms of investment and can make the difference between a company that soars to new heights and one which crashes and burns.
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Private equity and venture capital investments are fundamentally different from each other. They offer different types of support to start-up founders and provide their own unique risks and rewards.
In this article, I will take you through exactly what private equity and venture capital investments are, along with the pros and cons of each so that you can make an informed decision about which is best for you.
What is Private Equity?
Private equity is a simple form of investment where the investor acquires shares in a business in return for an agreed sum.
As described in my book, The Art of Startup Fundraising, this type of investment is primarily found in businesses that are not publicly listed or trading on an exchange.
Private equity investors tend to have large amounts of investment capital at their disposal. These investors are made up of either private individuals or firms looking to buy a share of an upcoming or established company.
What is Venture Capital?
Venture capital is a form of financing given to a start-up or new company to help it reach its initial goals or to bring its products to the market.
Most venture capital investments are made by either private individuals or investment groups looking to attach themselves to the next big company before they establish themselves.
This means that investment is usually far cheaper than when the company has established itself later.
Investment groups include investment banks and venture capital groups which pool their money together and are overseen by an investment expert or representative.
1] What is the Difference Between Private Equity and Venture Capital?
To summarize then, private equity is an investment in return for shares, often in a business that is already established to a degree. Venture capital is offered to brand-new companies looking to reach their first milestone or next fundraising round.
Often, a private equity investment is made when a company is deteriorating in some way or is making a loss. The private equity investor believes that their investment can be used to right the ship and turn this loss into a profit.
Private equity investments usually result in the investor bringing their input to the table to streamline the business and make it more cost-efficient. Private equity firms investing in a company tend to buy either 100% of a company’s shares or at least a large majority so that the investor has control over how the company is run.
Venture capital investments differ from private equity investments in that they are mostly used to fuel growth. This could be bringing a product to market or even just product development. The function of venture capital investments is to achieve rapid growth in a business that is young.
Venture capital investors rarely buy a controlling stake in a startup. They are investing in the founder and their concept. Venture capitalists tend to invest in less than 50% of a business, sometimes much less than that because new companies have a larger risk associated with them.
As a rule of thumb, private equity investors tend to invest huge amounts because they are trying to buy an entire company that is already established. Venture capitalists tend to offer around a tenth of the same investment, but require a smaller slice of the business.
2] Advantages of Private Equity
Private equity investment is associated with a number of advantages and disadvantages for both the investor and the target business.
The advantages of private equity investment include having the financial resources to propel growth to previously unseen levels for the target company.
Private equity investment also involves hands-on expertise from investors and their associates who have the skills, talent, knowledge, and network to maximize a company’s value.
With private equity, other types of investments within a company structure can be made such as providing management incentives to increase management performance. Private equity investment often identifies those most talented as a company and makes a point of making them feel valued.
The number one aim for private equity investors is to rejuvenate a company so that it reaches new levels of success.
3] Disadvantages of Private Equity Investment
While private equity investment is usually beneficial, there are some downsides that occasionally develop.
Private equity may mean that a founder loses complete control of the company unless they are kept on in some capacity or rewarded with shares during the purchase.
The disadvantages of private equity investment include transparency. This is where business methodologies and processes are sometimes not obviously available to the public, though legislation is attempting to force private equity investors to maintain a level of business transparency.
Private equity sometimes uses debt in order to finance deals. In some circumstances that can lead both the business and the investor into a financially precarious situation.
Though private equity investment attempts to hold onto the most talented people in a company, it does tend to involve experimentation within a company structure. For this reason, a high turnover of staff is quite common after a complete buyout.
4] Advantages of Venture Capital
A good M&A advisor will share that venture capital investment offers its own advantages and disadvantages.
Venture capital investment provides a relatively young company with the ability to grow and expand in a way that it would not otherwise have been able to do so. This is achieved without the need for credit facilities such as bank loans where the interest repayments can be difficult.
Venture capitalists take the financial risk in investing without requiring any immediate interest repayments.
Because venture capitalists specialize in businesses at the beginning of their journey, they will often offer more than just simple finances. They will offer expertise and knowledge to help take a business idea from its earliest infancy to maturation.
As venture capitalists tend to invest small amounts of money, there are more of these investors out there. This means it’s not as difficult to attract venture capital investment as it is private equity.
5] Disadvantages of Venture Capital
There are also some inherent disadvantages to venture capital investment.
When venture capitalist invests at an early stage in a start-up, they often require a stake in the business. This can dilute ownership for the founder of the start-up and even take some control away from them. Venture capitalists tend to join the board of any company they invest in.
Securing venture capital can be a long and arduous process.
Any business plan must be stringently detailed, then discussions and stress testing of an idea can be undertaken via market research. Venture capitalists will do a significant amount of due diligence when considering investing. This is not always ideal for a start-up when it needs financing in the short term.
Although venture capital does not come with interest payments initially, investors will require repayment. This return on investment is often paid between 3 to 5 years later and can be very expensive.
Because venture capitalists aim to make their money as quickly as possible, they are often quick to sell their equity stake. This means that they can pressurize the start-up’s owner to sell the business too early before maximizing profits.
