Venture capital and private equity may be confusing terms. Both refer to a type of firm that will invest in companies with the goal of selling their investment later. However, these are two very different types of firms.
From the types of firms to the sizes of companies they invest in, venture capital and private equity are rather different. Let’s look at what each one is and how they are different.
What is Venture Capital?
MassChallenge.org defines venture capital as a “financial investment for new startups and emerging companies, which is provided by wealthy individuals known as venture capitalists.” Usually, venture capital investments are made by a pool of venture capitalists. They will put their resources together to create a limited partnership, which will invest in startups and high-growth companies.
What is Private Equity?
According to Investopedia.com, private equity “is equity—shares representing ownership of, or an interest in, an entity—that is not publicly listed or traded.” Typically, private equity investments are made by companies or high-net-worth individuals. Investors will buy shares of a private company.
They may also gain control of a public company and take it private by delisting it from the stock exchanges.
Most of the private equity investments are made by large institutional investors. This may include large private equity firms and pension funds. Usually, it’s a group of accredited investors making the investment.
Venture Capital vs Private Equity: The Key Differences
There are several key differences between venture capital and private equity. Whether you’re on the investment side or the business side, it’s important to understand these differences.
Private equity firms don’t invest in start-ups or in the early stages of a company. They choose to invest in well-established companies.
However, venture capitalists tend to invest in start-up companies and those in the early stages of growth. A venture capital firm seeks out new companies that could grow massively. They prefer the risk of a startup over a more mature company, which a private equity firm will prefer.
Size of Deals
Another difference between venture capital and private equity is the size of the investment. PitchBook states that about 25% of private equity deals found in the United States are between $25 million and $100 million. However, most venture capital deals fall under $10 million in Series A rounds but may get larger in later funding rounds.
Venture capital firms tend to take a percentage of equity when they invest in companies. A private equity firm often will purchase the entire company or at least a majority share.
It’s also common for shares to be split with angel investors, founders, and other venture capitalists or private partners when a venture capital firm gets involved.
Venture capitalists take more risk than private equity firms. They invest in higher risk, higher growth companies, while private equity firms tend to invest in more mature, lower risk, lower growth companies.
The higher risk for venture capitalists puts the returns expected at a higher rate. A venture capitalist will expect to make a huge return when a company they invest in does very well.
Private equity firms are targeting a 20% internal rate of return (IRR). While venture capitalists are also seeking the same type of return, they are typically hoping for a much higher rate of return.
Types of Companies
When you look at venture capital vs private equity, they don’t tend to invest in the same types of companies. A private equity firm will have a very diverse portfolio. It’s common to find investments in construction, energy, transportation, and healthcare in this portfolio.
Venture capital firms tend to focus on tech companies. They look for the next big advancement from a tech company. Disruptors are what venture capitalists seek, such as companies like Lyft and Uber.
It used to be common for private equity firms to buy companies and use a strip and flip approach. This means the company was going to be dismantled and completely restructured to be sold off by the firm. While this can still happen, it’s not as common today.
Private equity firms tend to be a bit less involved in the companies they buy, however. Typically, they look to expand and enhance the company before selling it.
Venture capital firms are very intimately involved when they invest in a company. This is especially true if they invested early in the history of the company. The level of involvement will be at the description of the business owner, however.
Venture Capital vs Private Equity: Pros and Cons
There are pros and cons of both venture capital and private equity. Let’s look at both.
Venture Capital Pros
- A great option for new companies
- Startups gain the funding they need, along with expertise from VC investors
- VC investors can help a company avoid common mistakes
- Offers higher returns for investors, in some cases
Venture Capital Cons
- Dilutes the company’s equity by issuing shares to investors
- Reduces the ownership when you take on a venture capital investment
- Has a higher rate of failure for investors compared to mature companies
Private Equity Pros
- Usually offers a company more than just funding
- Gain access to expertise as a company with a private equity investment
- Lower risk investment compared to a venture capital investment
Private Equity Cons
- Give up a majority share of the company, along with decision-making power
- Private equity firm can sell the company at any time
There are pros and cons to taking on a venture capital or private equity investment. The same goes for these two investment strategies. Whether you’re looking for an investment or an investment strategy, understanding venture capital and private equity are important.
While these are two different types of investments, they are similar in some ways. However, it’s pretty easy to see the differences. Venture capital is more common for newer companies and it comes with more risk. Private equity is geared towards mature companies and comes with less risk.