The terms “private equity” and “venture capital” are often used interchangeably because they both refer to firms that invest in private companies and then exit by selling their investments through equity financing. However, the two terms are quite different, especially in how firms involved in the two types of funding conduct business.

 

Private equity and venture capital (VC) invest in various types and sizes of companies, commit different amounts of money and claim different percentages of equity in the companies in which they invest. Let’s have a look at both of these investing categories.

 

What Is Private Equity?

Private equity means the ownership of shares representing an interest in a company that is not publicly listed or traded. High-net-worth individuals and investment firms invest in private equity; such investors buy shares of private companies or gain control of public companies with the intention of taking them private and ultimately delisting them from public stock exchanges. Private equity is not an asset class for retail investors.

 

Large institutional investors dominate the private equity world, including pension funds and large private equity firms funded by a group of accredited investors, notes Investopedia.

 

Advantages of Private Equity

Private equity can provide several benefits to companies that can’t raise capital on the stock market or take loans from traditional banks or lenders. Here are some advantages of private equity.

 

  • Fast access to working capital: For smaller private equity firms that know the target company, funding can be swift, giving the company higher cash flow, faster growth potential or even the ability to carry out a merger or acquisition.
  • Less bureaucracy: Private equity doesn’t have the legal and regulatory requirements of initial public offers (IPOs) and other conventional financing instruments. There are also no credit checks, loan covenants or loan interest payments, allowing the company to allocate the funds to improve its liquidity and speed up the execution of its plans.
  • Flexibility: Because private equity funds invest at different stages of a company’s growth, such investments can help a company try various growth strategies at different development stages. Different funding rounds from private equities can help a company turn an idea into a product, gain traction in a new market, acquire a competitor, merge with a lateral player or prepare for an IPO and go public.
  • Professional expertise: Because private equity funds typically want to generate a high return on investment (ROI) for their investors, they usually take a hands-on approach to guiding and managing the companies that receive their funds. Some private equity firms maintain expertise in a particular industry or niche and only invest in companies in that niche because of the professional background of the founders.

 

Disadvantages of Private Equity

Despite the many benefits of private equity funds, there are downsides, including the following.

 

  • Extremely risky: Private equity investments are high risk, mostly because of the large ownership stake the private equity firm takes in the target company. If the company fails to perform, the firm and its investors are exposed to losses. Another risk for private equity is the lack of regulatory oversight that traditional asset classes enjoy, and investors may not have total control over the receiver’s management. 
  • High barrier to entry: Private equity funds limit the number of individuals who can invest with them. Because the funds required for these investments are usually high and there is a dearth of solid, quality opportunities, even accredited investors are shut out from participating. Private equity investments are also usually complex and require long-term professional and institutional management, which limits them to the ultra-wealthy and large investment firms.
  • Inadequate transparency: Because the target companies are private, they do not need to comply with government-enforced accounting or reporting requirements. This leads to a lack of transparency as to the true health or financial position of the company. Unlike raising capital from the stock market, where businesses are required to publish their financial position and reveal any conflicts of interests, private equity investments occur largely out of public view.
    “If investors don’t perform adequate due diligence, it might be difficult to estimate the future performance of a company that’s receiving capital,” cautions Indeed. “This places investors’ funds at high risk, which makes it essential to perform thorough assessments and checks to verify a company’s claims before giving them private equity capital.”

 

What Is Venture Capital?

Venture capital is often seen as a subset or special situation of private equity: financing given to startup companies and small businesses that are considered to have high growth potential and above-average returns in a relatively short amount of time. As with private equity, funding for venture capital comes from accredited or high net-worth investors, or investment firms with expertise in the industry in which the portfolio companies operate, such as biotech or cleantech. 

 

For newer companies or those with a short operating history — two years or less — venture capital funding is both popular and sometimes necessary for raising capital, according to Investopedia. This is particularly the case if the company does not have access to capital markets, bank loans or other debt instruments. For example, a technology startup might not own physical assets, or its intellectual property (IP) might be difficult to value, so venture capital funding is the only way it can garner investment. A downside for the fledgling company is that the investors often obtain equity in the company and, therefore, have potential control over company decisions.

 

Advantages of Venture Capital

Venture capital has several advantages, including the following.

 

  • Industry-specific: Like private equity investors, many venture capitalists maintain expertise in a particular industry and bring that to the portfolio companies in which they invest. This benefits both the management of the portfolio companies and the investors participating in the fund.
  • Potential for exit: Successfully receiving venture capital funding, especially from a highly sought-after firm, usually means a successful exit. High-profile venture capital firms lend a type of “approval” to their portfolio companies, increasing interest in the portfolio company by potentially attracting new investors or partners.
  • Managed risks: While venture capital is still risky, venture capital firms often manage several funds and spread their investments across several portfolios. Additionally, venture capital firms as a rule invest in less than 50% of a target company’s equity, minimizing exposure and risk.

 

Disadvantages of Venture Capital

Venture capital has some challenges, such as the following.

 

  • Reduced control by company founders: Venture capital makes investors co-owners of the business, enabling them to exercise control over its management. This can cause problems if there’s a clash of interests between founders and investors.
  • High competition: In many startup ecosystems, there’s often a high level of competition for venture capital funding. This is especially true from sought-after firms, where an investment by the firm brings a certain caché. If a company’s business model, unique proposition and IP aren’t convincing enough for one firm, it might find it difficult to secure funding from other venture capital firms.
  • Higher cost of capital: Depending on the terms of the deal, the cost of venture capital might be higher than the interest paid on traditional loans. This is because taking venture capital funding from outside investors requires relinquishing some ownership and control.

 

Private Equity vs. Venture Capital: Key Differences

There are several differences between the two types of capital.

 

Maturity of Portfolio Companies

The most significant difference between private equity and venture capital firms is that private equity firms typically buy mature companies that are already established and have an operating history. Such mature businesses seeking private equity might be experiencing lower profitability, so they seek private equity investors not only as a source of capital but also as a source of expertise to help them turn the business around. 

 

Venture capital firms, on the other hand, mostly invest in startups with high growth potential.

 

Percent Ownership

Another difference between private equity and venture capital is in the percentage of ownership. Private equity firms mostly buy 100% ownership of the companies they invest in, whether alone or with a consortium of other private equity investors. As a result, the firm or group of firms is in total control of the companies after the buyout. 

 

Conversely, venture capital firms invest in 50% or less of the equity of the companies. This is to spread risk; most venture capital firms prefer to spread their risk and invest in several high-growth companies across their portfolios. The strategy is that if one startup fails, the fund is not substantially affected. To spread the risk even further, venture capital firms will have several funds, with multiple companies in each portfolio, each with a different risk profile.

 

Industries, Investment Vehicles

Private equity firms invest in companies from any industry, while venture capital firms generally limit themselves to startups in technology, biotechnology and “clean” technology. Such companies are generally early-stage, with little to no profits and IP that is difficult to value. 

 

Private equity firms also use both cash and debt in their investment, whereas venture capital firms deal with equity only. 

 

Your Partner in Private Equity and Venture Capital Transactions

Private equity and venture capital transactions, though they don’t follow regulatory guidelines, can still become quite complex. However, such transactions don’t need to rely on complex technology to get the deal done. A virtual data room (VDR) offers enterprise-grade security and document management features that are perfect for private equity and venture capital transactions.

 

Consider using a CapLinked VDR for all of your investing needs. Sign up for a free trial today.

 

Jake Wengroff writes about technology and financial services. A former technology reporter for CBS Radio, Jake covers such topics as security, mobility, e-commerce, and IoT.

 

Sources

Investopedia – Private Equity vs Venture Capital: What’s the Difference?

Pitchbook Blog – Private Equity vs Venture Capital: What’s the Difference?

Indeed – Private Equity vs. Venture Capital: Pros, Cons and Differences