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Private equity and venture capital often times get confused because they both invest in companies and use exit strategies by selling their investments in equity financing by holding initial public offerings (IPOs). While these two types of funding have similarities, they each perform in unique ways. In this article we will discuss what the differences are and how they work.
Similarities Between Private Equity and Venture Capital
Before we discuss the differences, we will discuss a couple of the similarities. Private equity and venture capital firms take money from outside investors and sink it into companies hoping they eventually get a return. Their structure is almost identical, with limited partners providing the money and general partners managing it.
The way the make money is also very similar. Both take the money that they gather from investors and put that into companies, mainly focused on profiting when the companies exit.
Understanding Private Equity and Venture Capital
Private equity is equity that is not publicly listed or traded. It is a source of investment capital from high net worth individuals and firms. The investors buy shares of private companies or gain control of public companies with the intent taking them private and taking them off the list from public stock exchanges. Private equity firms take 50% of ownership or more in mature companies that operate in traditional industries. They also usually invest in established businesses that are deteriorating because of inefficiencies. They invest in those because they believe that once the inefficiencies are fixed, the business can become profitable.
Venture capital is financing given to startups and small business that have a potential to breakout. The funding for this comes from wealthy investors, investment banks, and other financial institutions. The investment does not have to be financial but can be offered through technical or managerial expertise. For new companies or those with a short operating history, venture capital is a popular type of funding and necessary for raising capital.
The key differences between private equity and venture capital lie in:
- Types of companies they invest
- Levels of capital invested
- Amount of equity obtained through investments
How private equity works
Private equity investors commonly use leveraged buyouts. Leveraged buyouts is where an investor purchase stake in a company using both equity and a significant amount of debt which then must be repaid by the company.
When a private equity firm sells its portfolio companies to another company or investor, the firm makes a profit and distributes returns to the partners that invested in the fund.
Private equity risk
Private equity investors are more risk-averse than venture capital investors, they usually only invest in mature companies who have less of a chance of failure compared to a company that is at its early stages. They also invest in fewer companies because if even just one investment fails, it can have a huge impact on the fund.
How venture capital works
Venture capital firms open a fund and ask for commitments from limited partners to raise the money needed to invest in companies. If a venture capital invested in a company that was successfully acquired or goes public, then the firm makes a profit and distributes returns to the limited partners that invested in its fund.
Venture capital risk
Unlike private equity, venture capital firms do not aim to invest in startups. Venture capital firms make profit when the companies they have invested in get acquired or go public. They can also make a profit through the sale of company shares on the secondary market.
The Bottom Line
As you can see there are a few similarities between a private equity and a venture capital, but they have major differences as well. The one that you should choose should depends on your goal. If you like to work in transaction deals or are trying to make money in a short amount of time, private equity is the best option. If you are more interested in starting your own company and prefer relationships for analysis, venture capital is better.
