Despite being often used interchangeably, “private equity” and “venture capital” are not synonymous. Both terms refer to companies that invest in private companies for equity, but they accomplish the task in different ways.
What is Private Equity?
In private equity, a group of investors directly invests in a company. Private equity investors generally invest in mature companies that have passed the growth stage. Often, they provide funding to struggling businesses.
Additionally, some investors will acquire a business, improve its operations, and then sell it for a profit. Private equity investors always strive to generate a return on their investment by enhancing company value over its initial value.
Large institutional investors, including pension funds and large private equity firms funded by accredited investors, dominate the private equity sector.
Pros and Cons of Private Equity
A private equity investor will provide you with more than just cash — you will also benefit from their expertise. Private equity investors may be able to assist you in identifying potential areas for improvement if they have experience within your industry.
However, private equity investors typically own a majority stake in the business, meaning they have a say in managing the business. Their authority extends to the removal of executives or the making of significant business changes.
If they feel that it is the right course of action, private equity investors have the power to sell the company. Investors want to make money, and selling is viable if the right opportunity arises.
What is Venture Capital?
In technical terms, venture capital (VC) is a form of private equity. The principle difference is that private equity investors prefer stable companies, whereas venture capitalists typically invest in startups.
Venture capital is generally allocated to small companies with exceptional growth potential. VC investors usually engage in this type of investment because of the possibility of very high returns. However, it is not easily obtained and tends to be riskier than other types.
Generally, venture capital is provided by high net worth individuals, or what is referred to as “angel investors” or venture capital firms, to small businesses or up-and-coming businesses in emerging industries.
What are Angel Investors?
Angel investors represent a diverse group of individuals who have acquired wealth through various sources. Most are entrepreneurs or executives who have recently retired.
How Does Venture Capital Work?
A venture capital firm must establish a fund to raise funds needed to invest in companies. Through this process, they can draw from a pool of funds invested in promising private companies with high growth potential. As they grow, these companies go through different stages of the venture capital ecosystem. Venture capital firms tend to focus on one or two steps of VC funding, which impacts their investment strategy.
If a venture capital firm invests in a company that is acquired or goes public through an IPO, the firm makes a profit and distributes its profits to the partners who invested in the funds. The firm can also profit by selling some of its shares to other investors on the secondary market.
The Venture Capital Process
Any business seeking venture capital must submit a business plan to either a venture capital firm or an angel investor. Suppose the firm or investor is interested in the proposal. In that case, it must conduct due diligence, including a thorough analysis of the company’s business model, products, management, and operating history, among other things.
Following completion of due diligence, the firm or investor will pledge an investment of capital in exchange for equity in the company. Afterward, the firm or investor actively monitors the company’s progress and provides advice before releasing additional funds. Often, these funds will be provided in stages rather than all at once.
After a period of time, typically four to six years after the initial investment, the investor exits by initiating a merger, acquisition, or initial public offering (IPO).
Pros and cons of venture capital
Venture capital funding can benefit new companies in the early stages of development. As with private equity investors, venture capitalists can contribute their knowledge and expertise to the process.
In this way, you can minimize your risks and avoid many mistakes that startups make at the beginning. New businesses have a high failure rate, so it can be beneficial to have an experienced team on hand to provide guidance. Additionally, VC investors are well-connected and may be able to assist you in finding new opportunities.
In funding round, you dilute your equity by issuing shares to your investors. You will further reduce your ownership and control over the company if you have to raise additional rounds.
Why is Venture Capital Funding Important for Startups?
Venture capital funding is necessary for raising capital for new companies or those with a short operating history (two years or less). In particular, this is the case if the company has no access to capital markets, bank loans, or other debt instruments.
Is Private Equity Different from Venture Capital?
While there are some similarities between private equity and venture capital but also many differences, following is a brief overview of how they differ:
✅ Type of business:
Private equity investors typically invest in well-established businesses. Usually, these investors focus on struggling companies because of ineffective leadership or flawed process. Upon acquiring the businesses, they make significant improvements and sell them for a profit. Although the return on investment is low, they take on much less risk. On the other hand, venture capitalists are interested in companies with a very high growth potential and, consequently, are more willing to take on risks.
✅ Control over the business:
You give up a certain degree of control over your business whenever you bring on investors. Private equity investors are required to obtain a majority stake in the company, whereas venture capital investors need only a minority stake.
✅ Size of investment:
Private equity firms are typically responsible for investing $100 million or more in a single company. The firms invest in already established and mature businesses, so they prefer to concentrate on a single company. Such an investment is unlikely to result in total losses. Venture capitalists typically invest $10 million or less in each company since they mainly deal with startups with unpredictable chances of success or failure.
✅ Exit strategy:
Private equity investors usually seek to improve a business and sell it quickly. In the long run, they are not interested in the industry. On the other hand, VC investors are interested in the company’s long-term growth. They expect a substantial payout and are committed to staying until they have received it.
Conclusion:
Private equity companies make private equity investments, and they obtain shares of privately-owned companies or take control of publicly traded companies to turn them into private companies and remove them from the stock exchanges. Private equity companies invest in mature companies to maximize returns.
On the other hand, a venture capital investment refers to an investment made in a company still in its early stages of development but potentially outgrowing soon.
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