Venture Capital vs. Private Equity: Which Investment Strategy is Right for You?
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Summary:
Private equity and venture capital are fundamentally the same in that a group of investors or intuitional investors buy shares directly in a company. However, venture capitalists tend to invest at an earlier stage, whereas private equity firms tend to invest in more mature companies. Furthermore, VC investment usually relies on the growth of the company to make a profit, whereas private equity companies can make a profit via financial engineering, in which the intrinsic value of the company never actually increases.
In 1988, a seminal event in the airline industry popularized the term “corporate raider,” accompanied by images of an airport with hundreds of airline employees picketing. Financier Carl Icahn used something called a “leveraged buyout” to take over the airline TWA, which had been in business since the 1930s. In those days, the leveraged buyout as a means to invest in companies was called corporate raiding. These days, Carl Icahn still invests using leveraged buyout structures, but under a different name, “private equity.” Is private equity just a new name for corporate raiders? And how is venture capital different? If you are looking to invest using venture capital or private equity funds, pay attention. Here is what you need to know.
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Private equity vs. venture capital in short
Private equity describes investment partnerships that buy and manage companies with the goal of turning a profit. Private equity is considered private because the money raised is from private investors rather than the public market. Furthermore, private equity firms can invest in publicly traded and private companies. In investment banking, private equity is a vague term; thus, many investments can be called private equity, including venture capital. In practice, however, the private equity industry focuses on buying companies at a more mature stage of growth.
Venture capital is a type of private equity (venture capital private equity) that is more focused on the early stages of companies — private investors buy in with the hope of the company growing. The idea is that the company grows and is either acquired or goes public, allowing an option for investors to exit.
Pro Tip
Herein lies a fundamental difference between the private equity and venture capital industries. Most of the time, in order for a venture capital firm to turn a profit, the target companies/portfolio companies have to grow. With private equity, investors can turn a profit on their investment capital through certain types of financial engineering. The company is not required to grow or even be profitable.
Private equity
Let’s take a look at how it works. There are many different types of private equity, including venture capital. The most common types of private equity investments are as follows:
Leveraged buyout
Buying a company using leverage with the hope of turning a profit. The companies can be public, private, or public with the goal of turning private.
Growth equity
Investing in a company to give it the capital needed to grow, with the goal of turning a profit based on the increased equity price once growth has been achieved.
Real estate
Investing in the equity portion of a development or buying up equity positions in existing assets.
Venture capital
Like growth equity, investing in a company that gives it the capital needed to grow, with the goal of turning a profit on growth, but at an earlier stage.
Mezzanine finance (using PE money)
Lending money in a mezzanine structure to companies and charging them interest and possibly part of the upside.
The private equity industry
Although these are all types of private equity, the most commonly used strategy for what people call the “private equity industry” is the leveraged buyout.
How does a leveraged buyout work?
A leveraged buyout (LBO) uses a significant amount of funds from third parties to purchase a target company either in the form of debt or bonds, hence the usage of leverage. In most LBO deals, the private equity fund or partnership puts up 10% in equity and raises 90% debt/leverage.
However, the key to leveraged buyouts in the private equity industry is how the deal is structured in terms of who takes on the debt and who makes the profit. This can be explained in the chart below:
A leveraged buyout works like this: Private equity investors (funds, partnerships) will go after a target company. Before doing this, they will form a new holding company to buy and hold the company they target. The new holding company will then have an injection from the private equity company (typically 10%-ish), and then the further 90% they will raise via debt from a lender or bonds.
So who is responsible for the debt?
Here is where it gets tricky. The private equity fund does not owe the debt; it’s owed by the holding company, which is used to buy the target company. This means that the new owner of the target company (holding company) owes the debt, which means the target company has now taken on the debt that was used to buy it in the first place.
Now the private equity fund has two options to make a profit:
Grow the company/turn the company around and sell it
They can continue paying the debt from the holding company through the target companies’ cash flow and hope that the value grows and it makes a profit. Pretty simple, right? They bought a company, grew it, and sold it for more money.
Extract money from the company via fees and dividends
A private equity LBO can make money another way. As they are now the majority owner of said company, they can take cash flow out of the newly acquired target company. Many times this is done by pumping up the cash flow, stripping assets, and firing employees. Remember, the target company is now saddled with the debt that was used to buy it in the first place. The new debt-laden target company might be forced to file for bankruptcy as they are unable to keep up with the debts. The creditors lose, the employees lose, but the private equity firm makes money as they take out their capital and profits beforehand in the form of fees and dividends. For those curious about an example of this real life, the Toys ‘R Us bankruptcy in 2005 is a good case.
The venture capital industry
As mentioned above, venture capital is technically a subset of private equity, but unlike most of what is considered the private equity industry, VC focuses on early-stage growth equity investing. That is to say; they invest in companies at a very early stage with the idea that their investment will grow exponentially.
They hope to exit the investment in three ways:
Equity position sold for a profit
The VC fund’s equity investment has gone up, and they sell it to another investor, either private or institutional.
The target company is acquired
The target company is acquired by another company, and the VC equity position is sold for a profit.
Target company goes public
The company goes public, and the VC can now “cash out” or sell their positions on the open market.
Most of the time, VC funds and partnerships want the company to either be acquired or go public.
How does a VC deal work?
A company will raise money from a venture capital firm during a series of raises. Each time a company raises capital from investors, there will be a pre-money valuation and a post-money valuation which can move up and down. For more on how that works, read our article on pre-money vs. post-money.
Series A example: Titus Tech fundraising
Series A round on 9/28/2018
Pre-money valuation: $10 million
Investment raised: $5 million for 10% equity in the company
Post-money valuation: $50 million
Series B round on 8/1/2019
Pre-money valuation: $50 million
Investment raised: $10 million for 10% equity in the company
Post-money valuation: $100 million
This is an example of a Series A and Series B fundraising round. You will see that Titus Tech raised money at a $50 million valuation. Let’s say that the VC fund that invested in Titus Tech is called Nuggets Capital.
When the Series B round investment hits, the valuation goes to $100 million, meaning Nugget Capital has doubled its investment on paper. As mentioned before, theoretically, they could sell this to another institutional investor and take the profits. However, let’s use an example of Nuggets Capital holding onto its Titus Tech investment until it goes public in 2027.
Public offering in 2027: $2 billion valuation
10% equity: $200 million
Original price paid: $5 million
Profit for Nuggets Capital: $190 million
ROI: 3,600%
Nuggets Capital made a $190 million return (19x) on only $5 million. And herein lies the secret of VC capital. Most investments fail, but those that succeed can return an incredible amount of money. As the companies are at such an early stage, the upside potential is massive, but the risk of failing is far greater.
Silicon Valley is the heart of VC, but it’s not the only player
VC money is traditionally associated with Silicon Valley and California, but the East Coast is also a VC center, according to Howard Lubert, an area president with Keiretsu Forum, an angel and VC-investing network. “California was responsible for 43% ($104 billion) of the roughly $235 billion in VC investments in 2022,” he says. But, “The East Coast delivered a respectable $75 billion or 32%, far more than the rest of the U.S. combined, so clearly, the East Coast plays a significant role in the VC investment space.”
However, California and Silicon Valley are the heart of VC finance, according to Jon Dishotsky, an investing partner at Giant Ventures. “Silicon Valley will always be the ‘Hollywood’ of finance,” he says. “The combination of academia, capital, and culture makes it unique for founders, such that it is an unparalleled beacon of innovative thought and talent. For example, in the most recent batch of Y Combinator, 86% of W23 founders lived in the Bay Area. In short, all the best early-stage founders are still flocking there, if for nothing else, to absorb the ‘je ne sais quoi’ and bring it back to the place where they build.”
The combination of academia, capital, and culture makes (Silicon Valley) unique for founders, such that it is an unparalleled beacon of innovative thought and talent. - Jon Dishotsky, investment partner at Giant VenturesClick to Tweet
Raising VC or PE money for your business
If you need to raise money for your company or business and looking at private equity vs. venture capital, there are some important considerations. If you have an offer for private equity to buy your company, what is the plan? Will they invest in growth equity? Or do they want to strip assets and bankrupt them? If you are looking for VC investment, remember that VC funds want investments with HUGE growth and scalable potential. Your ability to prove that with forecasts and pitch decks is of utmost importance.
VC Funds vs. PE funds (LBO) for investment
It’s important to note that only some PE and VC funds are available to retail investors on the public market. Many are for private and institutional investors only. Both types of funds can make stellar returns. You should look at funds with a track record, good returns, and that you personally believe in.
FAQ
Is private equity part of venture capital?
No, venture capital is a type of private equity. However, private equity firms engage mainly in leveraged buyouts for more mature target companies, whereas venture capital firms invest in early-stage companies hoping they grow.
Is venture capital riskier than private equity?
Yes, regardless of the portfolio companies, VC is riskier than private equity. This is because VC investment is at a very early stage in which companies have a higher risk of failure. Furthermore, VC firms typically don’t have a second exit strategy that revolves around recouping the money through fees and dividends like private equity funds.
Is Shark Tank a venture capital?
Yes, Shark Tank features a myriad of venture capitalists who look at early-stage companies before they decide to invest with a share of equity.
Key takeaways
- Private equity consists of private investors buying companies directly and not through the public markets. Venture capital is a subset of private equity, also called venture capital private equity.
- The difference between the VC industry and the PE industry is in their strategies. Venture capital funding focuses on early-stage growth equity investing, and PE focuses on buying more mature companies, typically through a leveraged buyout.
- Private equity firms can make money in two ways: by investing in/turning around a company and growing its value or by using financial engineering to extract a profit.
- If you have a business, be smart about how you take money and who you take money from. If you are an investor, both industries can make great returns; it’s really up to the individual investor as to which they strategy they prefer.
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