What is the difference between private equity and venture capital?
Private equity is sometimes confused with venture capital because they both refer to firms that invest in companies and exit through selling their investments in equity financing, such as initial public offerings (IPOs). However, there are major differences in the way firms involved in the two types of funding do things. They buy different types and sizes of companies, they invest different amounts of money and they claim different percentages of equity in the companies in which they invest.
Private equity firms mostly buy mature companies that are already established. The companies may be deteriorating or not making the profits they should be due to inefficiency. Private equity firms buy these companies and streamline operations to increase revenues. Venture capital firms, on the other hand, mostly invest in start-ups with high growth potential.
Private equity firms mostly buy 100% ownership of the companies in which they invest. As a result, the companies are in total control of the firm after the buyout. Venture capital firms invest in 50% or less of the equity of the companies. Most venture capital firms prefer to spread out their risk and invest in many different companies. If one start-up fails, the entire fund in the venture capital firm is not affected substantially.
Private equity firms invest $100 million and up in a single company. These firms prefer to concentrate all their effort in a single company, since they invest in already established and mature companies. The chances of absolute losses from such an investment are minimal. Venture capitalists spend $10 million or less in each company, since they mostly deal with start-ups with unpredictable chances of failure or success.
Private equity firms can buy companies from any industry, while venture capital firms are limited to start-ups in technology, biotechnology and clean technology. Private equity firms also use both cash and debt in their investment, but venture capital firms deal with equity only.
These observations are the common cases. However, there are exceptions to every rule; sometimes one firm type does things out of the norm for its kind.
You are asking a distinct question which is quite interesting. Private equity involves a private equity fund taking control of a company, usually using a high percentage of debt (70-100%) in the purchase price combined with 20% equity. They change the management of the company, incentivze the new management with a piece of the ownership, and have them completely change the way the business operates, with the goal to make it more efficient, more profitable, and grow the business. By doing so, in 5-10 years at the end of the fund, they will sell the company for a higher price, or take it public at a greater multiple than the price they paid. So typically, private equity buys into large existing businesses with operations which have been established over a number of years. Venture capital is typically a situation where a fund will invest capital in an early stage technology company, sometimes it will be nearly at the start of a company (called round a), and in other cases it will be later as the technology company has been building a business. The venture capital company will get board representation and try to help grow the company into a much larger enterprise in 5 years, think going from 1 million or 5 million in revenue to 50-500 million in revenue. Venture capital firms are trying to get an exit where they make 5-100 times their money in the 5-10 year lifetime of their fund. Usually, on ten investments, they want one of the ten to make 10-100 times their money and that pays for the other 9 investments where they don't. Another difference between private equity and venture capital is the amount of money invested in each specific company. In some cases, private equity can pay hundreds of millions or even billions. Venture capital, especially early stage, will invest 500K up to maybe 10 million, so the degree of capital used is far different. I hope this helps answer your question.
Private Equity (PE) and Venture Capital (VC) are investing strategies that sit at the end of a spectrum of private company investments. VC sits on one extreme and focuses on investing in a range of start-up and growth companies before they become profitable. Because these companies have limited operating history and limited profits, if any, they cannot access the public markets to help finance them in normal times. Thus, they require private investors to provide funding to help them reach their potential. Most VC-backed companies fail and a venture capitalist is considered to be doing a good job if 4 companies in a portfolio of 20 generate positive returns. Given the high level of risk and company failure, venture capitalists expect these 4 companies to generate huge returns (10x+ their initial investments) to compensate for the losers.
Most positive exits occur through IPOs, although strategic M&A is a major exit strategy these days. PE sits on the other extreme of the spectrum and invests in mainly mature, profitable companies and some growth companies that can handle leverage to help generate investor returns. PE investors typically invest in the equity of private companies and use leverage to fill the valuation gap. Valuations are generally based upon a measure of modified cash flow, EBITDA. PE companies are able to tap the public and private financing markets to finance their operations, due to their size and positive operating history. PE investors will typically have 10 to 15 companies in a portfolio and will expect all of them to generate positive returns with low losses. Any returns over a 3x multiple of invested capital are considered to be a home run as most PE investors will target 2x returns and IRRs in the mid-to-high teens on a single investment. PE investors typically sell their companies to other PE firms, strategic acquirers, or through IPOs.
With private equity, assets are combined of multiple investors to perform transactions. Using their pooled resources to acquire parts of a business or entire companies that are in distress. They do not maintain ownership for the long term and instead prepare some sort of exit strategy after several years. Private equity firms seek to improve upon an acquired business and then sell it for a profit.
Whereas, venture capital invests in a businesses earliest stages of operation. Venture capital takes on more risk to provide new businesses with capital so that they can begin operating and earning profits. It is often the startup capital provided by venture capitalists that gives new businesses the means to become attractive to private equity buyers or eligiblity for investment banking services.
The biggest difference is the stage at which their target is in. Venture capital firms, for the most part buy stakes in companies that are young, usually pre-IPO including day one or even pre-operational. Private Equity firms usually purchase firms that are slightly more mature and established and have operations- they can be either private firms or public firms.
I once read an interesting quote on the difference between the two: “In Private equity you start with the numbers and then make everything else into the number. In Venture Capital you start with the people and then see what numbers you can make"