Venture capital and private equity

Venture capital and private equity differences

While you may have heard of different investors, the difference between venture capital and private equity can be somewhat confusing. Let’s sort things out in this article and explain all the differences between the two. When you understand these differences, not least the two business models, then we will list the businesses that will not attract venture capital or private equity.

Many entrepreneurs consider investors to finance a product development, an expansion or an add-on acquisition. What is the difference between venture capital and private equity, when can venture capital and private equity be used and when to be avoided?

Venture capital and private equity history

Venture capital and private equity share their historical origins. Both spring from the late 1940s with the creation of the American Research and Development Company by Georges Doriot and his partners, Ralph Flanders and Karl Compton.

Their most famous early venture capital investment was in 1957 when they invested $70 000 into Digital Equipment Company (DEC). They made more than 500 times the value of the investment when the company was listed on the stock exchange in 1968.

Private equity emerged when investors in the 1960s started to target well established, family-owned business that were gradually failing. These companies were acquired with the support of banks who otherwise stood to lose money if the company would have gone bankrupt.

Private equity transaction boomed duing the 1980’s when leverage buyouts became popular. Private equity funds leveraged their return financing bids on businesses with a mix of equity and debt.

Private equity managers Kohlberg Kravis Roberts & Co acquired RJR Nabisco in 1988. It was the largest leverage buyout in history and sent chook waves throughout the business community. A symbol of greed of the 1980’s. Barbarians At The Gate is a well written, easily-read and exiting book about this transaction. Read it! You can find it at Amazon.

What venture capital and private equity have in common

Venture capital and private equity certainly have things in common. They are both are funds where investors place capital that is invested in different companies with the aim to return a profit to the investors.

This is where the similarities end. The approaches to investing capital and turning profits is differencent between venture capital and private equity.

What sets venture capital apart from private equity

For most entrepreneurs, sourcing capital to a company at some point is both an inevitable and a complex, time-consuming process. We’ll differentiate between venture capital and private equity on a number of different aspects:

  • Industry focus,
  • Target company size preferences,
  • Target company development phases,
  • Acquisition stakes,
  • Risk appetite,
  • Deal structuring and value creation.

Recently, the distinguishing traits that characterise venture capital and private equity have become less clear-cut. For instance, when private equity invest in companies in an earlier development phase than what is typically their sweet-spot. Or when larger venture capitalists mix up their equity investment with the introduction of debt elements.

For this article however, we look at the traditional characteristics and the difference between venture capital and private equity. We’ll start by looking at venture capitalists.

Venture capital investors

Venture capital aim to supply capital to early-stage start-ups that have very strong growth potential. Typically venture capital organize as investment managers to an investment fund that attract institutional investors and similar capital. The fund invest in target companies for a minority equity stake. Strict milestone targets are set and to reach those is a pre-requisite for continued funding.

Venture capital are experts in spotting start-up companies with unicorn potential. However, most venture capital have limited resources to operationaly help individual companies once the investment is done. The business model is to spot potential unicorn candidates, not to help entrepreneurs with sales and operations.

The venture capital business model is to find a large number of potential high-growth companies. One or two of those companies are expected to make the return for the entire investment fund. The challenge is not knowing which of all the investments who will end up making that return. The majority of the ventures will fail meeting all expected milestones.

Venture capitalists are important for the development of technology and knowledge-driven industries. They provide financing and networking opportunities to ventures that otherwise would have difficulties developing. Early stage startups are risky and not able to secure bank financing. Bank’s are not first-line risk takers but second-line capital providers for mature businesses in mature industries.

Venture capital – technology focus

Venture capital are mostly known to invest in technology-driven companies with an emphasis on software, biotech, medtech and clean-tech industries. This is not to say that there are no exceptions. There is a clear bias towards technology-driven start-ups that has very large scaling potentials. Staying in one industry sector also contributes to limiting the risks inherent to the investments.

Each investment must have the potential to yield a significant return to make the venture capital business model work. Only a few will succeed and need to make the entire fund to reach its return expectations. In recent history, only technology-driven ventures have yielded such significant growth.

Product delivery to customers is cost-efficient in software-based businesses. These start-ups require relatively limited funding in order to develop their product or service. Leveraging the technology to scale is also relatively quick and with significant economies of scale advantages.

These software-based companies often have the ability to quickly serve a global market. Not as easily accomplished for traditional industries.

These technology industry characteristics contributes to the significant return potential that is needed to fuel the venture capital business model.

Venture capital – target company size and stake

Venture capital invest in start-ups and early stage businesses. The target companies are fairly small and each investment is reasonably limited in size. A venture capital fund makes a very large number of investments which is the reason why venture capital is specialized to find interesting businesses and not to develop each and every one of them.

Venture capital – target company risk profile

Given that venture capital focus on early stage start-ups, they operate in a high-risk segment. The number of companies not reaching the aggressivly expected milestones are many.

By investing in a start-up with a technology-driven product or service, venture capital limits themselves to an investment decision risk and to an execution risk. The execution risk is the risk that the entrepreneur will not be able to scale the business as expected.

Venture capital – deal structuring and value creation

Venture capital typically acquire minority stakes in target companies with equity, without leveraging the capital against lenders. A primary reason for this is the inherent high risk in their investments.

A venture capital investor expect that a significant number of investments in a fund will fail to develop as expected. Fail to meet expected milestones. The challenge is to no know which those investments are. The consequence is that each investment must have the potential to yield a 30x return or more. The Value creation is the difference between the value of the shares held at the time of divestment compared with the value at the time of the initial investment. Corrected for the time value of money.

Venture capital and private equity investment stages

Private equity investors

Private equity has matured and become a significant and important part of the business landscape. Large private equity managers have started to diversify their businesses and become involved not only in leveraged investments in mature companies, but also in mezzanine lending, mortgages and other specialized private equity financing techniques.

While there are many different private equity firms, one important trend is that the big firms have gone truly global and manage vast numbers of funds. The top 10 private equity firms in the world combined represent around $800 billion in committed private equity investments. In early 2020, private equity is holding unprecedented amounts of cash, so-called dry powder, totaling around $1.500 billion.

Private equity firms are known to engage in so called leveraged buy-outs. One example can be to take a public company private. The private equity fund will acquire all shares and de-list the company from a stock exchange. Other investment example is to acuire a business area from a major multi-national company. A third example include distressed circumstances where large companies require capital to revive.

Private equity targets large, mature businesses in stable industry sectors and help scale sales, improve operations and make ad on acquisitions. The private equity business model is much more operationally focused than the venture capital business model. Compared to venture capital, private equity investors acquire companies where the business risks are low.

Th institutional investors who invest in private equity funds, the general partners, are looking for long investment terms with stable returns. They also look for sizeable investment opportunities and private equity funds are usually much larger than their venture capital counter-parts.

Private equity – mature focus

Where venture capitalists focus predominantly on technology-driven start-ups, private equity is looking at companies across basically all industries. Rather than specific industries, the focus is on finding companies with the right profile.

Large industrial companies was the main target for private equity for many years. The conglomerate business model became outdated in the 1990’s and private equity acquired subsidiaries from these multi-national corporations.

Gradually running out of target companies, retail became the next big target industry for private equity alongside infrastructure investments. Retail store operations was relatively easy to scale to large retain store chains with branding, purchasing and logistic synergies.

Telecom was a third popular private equity target with massive investment needs when the business model changed with the demand for data traffic. In more recent years data centers and technology intense industrial companies have become fashionable. Renewable energy infrastructure, lithuim-ion battery manufacturing and data-communication technology are areas that now attract private equity. Major system-vendors and infrastructure providers that operates within the electric vehicle industry will likely be the next big target for private equity.

Some private equity firms specialize in specific industries. Larg private equity firms divide themself into subdivisions, each focusing on specific industries or specific types of situations.

Private equity – target company size and stake

Private equity targets medium-sized to large companies where they are able to acquire a majority if not the entire company. Control is important for the private equity business model that is very much about sales and operations improvements.

Private equity engage in fewer deals than the venture capital. They look to deploy significant money in each deal including follow up investments and possible add on acquisitions. That’s why private equuity transactions are much bigger than venture capital transactions.

Private equity has to focus on the success of each individual investment because they make fewer investments per fund. Usually the fund cannot meet its return expectations if one or two of their investments fail. All investments basically need to performa from good to excellent. This is also a key difference from the venture capital business model. This is why private equity contribute with industrial advisors to help develop their businesses.

Private equity – target company risk profile

Typically, private equity look for medium to low risk companies. Examples include companies requiring investments to renew products or production facilities. Other examples are new strategy situations that can lead to new growth paths.

Private equity targeted business are large and mature which also limites the risks compared with small, early stage startups.

Private equity – deal structuring and value creation

In the early days, private equity was about financially engineered deals. Significant value creation came from leveraged buy-out structures where the investor used the caompany’s cash-flow to reduce debt levels during the investment period. Gradually, private equity have became more focused on achieving operational improvements in their portfolio companies.

Today, private equity firms draw on a full range of capabilities to achieve value creation: Operational and financial performance improvements; strategic development; product development and more. All private equity investment firms engage senior industrial advisors to help their companies to grow, build operational excellence, enter new markets and make add-on acquisitions.

Some businesses will not good for venture capital or private equity

Some businesses however have major difficulties to attracted venture capital or private equity. Simply because they do not fit with the unicorn-targeted venture capital model or with the mature large business private equity model:

  • Typical mom and pop businesses may be very good at what they do. Usually they are not very scalable on a global basis however.
  • Export and import agencies have an inherent limited margin, which is a problem. They are also being squeezed between a troubbled retail industry and online giants that source their own goods.
  • Manufacturing subcontractors without their own products have similar challenges as export and import agencies. They will not attract venture capital or private equity. Investment companies or other long-term conglomerate-type businesses sometimes target these kinds of businesses.
  • The construction business suffer from long permit processes, economic cycles and political risks. This sector is also off the rader for venture capital and private equity.
  • Real estate is an asset class of its own. Real estate attract massive investment appetite outside of venture capital and non-infrastrcucture private equity.

Venture capital or private equity for the entrepreneur?

Typically, private equity is not the main focus for early stage entrepreneurs or entrepreneurs with smaller to mid-size businesses. Private equity focus on mature companies that sell for at least $200 million per year but commonly well beyond that level.

Early stage businesses that aim to finance the launch of their products shall focus on familly and friends and business angels.

There are also early-stage venture capital available focusing on specific cutting-edge technologies with true global potential. The early-stage nature makes the risk high not hitting that unicorn status ten to fifthteen years from now. Hence the need for true global potential but also a strong entrepreneurial team deemed resiliant for the next 10 – 15 years.

Large, mature businesses are very capital intense infrastructure businesses will attracted private equity investors.

As much as investors will want to do thorough due diligence of the entrepreneur and his venture: Entrepreneurs should understand that they also need to make their own assessment of whether an interested investor is the right match for the company.

Knowing the investment criterias, strengths and weaknesses of specific investors makes it easier to find the best investor suitable for a certain venture.

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Jonas Florinus

Jonas Florinus

Jonas has 25 years operational experience growing businesses, 10 years with venture capital and private equity and more than $8 billion in personal transaction experience. For the last 5 years Jonas has been an entrepreneur himself.
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