Private equity and venture capital funding are both considered alternative investments, but there are significant differences between the two.
Private equity and venture capital are two ways business owners can shore up cash to run or grow their enterprise. Many business owners think these two funding options are interchangeable, but there are big differences.
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What is the difference between private equity and venture capital?
Private equity and venture capital fall under the broad umbrella of alternative funding, but that's where the similarities end. These funding methods target businesses at different stages of their life cycle, with owners giving up varying degrees of control.
"Venture capitalists focus on high-growth companies that have the potential to disrupt the industry and are growing at a high rate," Zsuzsanna Fluck, director of the Center for Venture Capital, Private Equity and Entrepreneurial Finance at Michigan State University, told business.com. "Private equity is more about middle-market companies that are relatively stable and more mature."
The size of your business, the industry you operate in, and your prospects dictate which alternative investment method makes sense for you. Before we delve into the differences, though, let's look at what private equity and venture capital are.
What is private equity?
Private equity (PE) is a type of alternative investment in which a private equity fund and/or investors make direct investments in privately held companies. Institutional and retail investors provide the capital, which the business uses to buy new equipment or technology, pursue bolt-on acquisitions, chase growth opportunities, or bolster cash flow.
Examples of private equities
Private equity funds can come from a number of sources. The most common source, though, are equity firms. There are several types of common equity firms, including:
- Insurance companies
- Investment funds
- Credit unions
- Pension funds
- Investment banks
Major companies have been purchased through private equities many times. Major companies have been purchased through private equities many times, and it is a common occurrence on the show "Shark Tank." It is important to distinguish between PE investments and publicly traded investments. Publicly traded companies can be purchased in general, but it does not qualify as a PE unless the company becomes private at the end of the deal.
What are the common PE strategies?
A private equity fund is motivated to make investments in private companies for several reasons:
Buying out the company: A common practice among private equity companies is to buy a business outright in order to improve it and sell it for a profit. This is known as a leveraged buyout. Alternatively, the PE firm can launch an initial public offering – which is when a private company sells shares to the public.
Providing distressed funding: If the business is struggling, PE investors will provide distressed funding to turn around its operations or sell off its assets for a profit. Typically, a private equity firm would get a majority stake in the business seeking the funding.
- Cashing out founders or other investors: PE investors may want a business, but not the people running it. To that end, they use PE funding to buy out the founders or existing investors. Private equity can also be used to expand the business or recapitalize if the enterprise is struggling.
Private equity investors tend to focus on mature, stable companies that have already exited the growth stage of the business cycle.
"Some of them focus on small companies, but it's not typical," said Fluck. "They typically invest in companies with $100 million to $500 million or more, and some middle-market companies that are below $100 million."
What are the pros and cons of PE?
Like any type of funding, private equity has pros and cons. On the positive side, PE investors bring more than cash to the table – they offer expertise and experience.
"PE investors usually have some expertise in the industry and may want to help acquire other companies and get bigger," said Steven Neil Kaplan, professor of entrepreneurship and finance at the University of Chicago's Booth School of Business. "You may not be running it as well as you can, and they bring in the real expertise."
The biggest disadvantage of PE investments is that business owners must give up control. PE investors typically get a majority stake in the operations, which means they have free rein to get rid of executives (including the owner), implement changes and sell the business. If the PE investors want to lay off most of your staff, you won't be able to do much about it.
The business could also be sold. PE investors are in it to make money. They want to improve the business, sell it for a profit and move on to the next investment.
What is venture capital?
Venture capital investing is when a group of investors or funds inject cash into a business in exchange for minority stakes. Like private equity investors, venture capitalists invest in private companies.
Examples of VCs
To better understand venture capitalism, a few examples can be helpful. Perhaps the most prolific venture capitalist in the world is Google. The company has a division known as GV. The entire purpose of the division is to invest in promising companies to help the company expand. GV is why you hear about some of the more interesting or random Google projects, like their fiber internet, wearable technology, and self-driving cars.
On "Shark Tank," the investors on the show frequently make venture capital investments. The main difference is that with venture capitalist investments, the investor is not taking control of the company. Instead, they are providing cash to jump-start business, and they usually take a noncontrolling equity stake as compensation for their investment.
What are the types of venture capital?
Venture capitalists and venture capital funds invest in startup companies at different stages of the business life cycle. The three main types of venture capital are seed capital, early-stage capital, and late-stage capital.
Seed capital: This funding is for businesses that are just getting up and running; they don't have a product or a company structure yet. Investments tend to be small at this stage. Funding is often used to develop a product, cover setup costs, or conduct market research.
Early-stage capital: This type of funding is geared toward companies that have been running for a couple of years and are in growth mode. The business has a structure, management is in place, and revenue is rising. Funding is typically used to boost sales, cut costs, and enhance operations.
- Late-stage capital: This stage of funding focuses on companies experiencing fast growth and looking for funds to get even bigger. Companies raising this type of funding have already disrupted the marketplace.
"Venture capital is for businesses in the earlier stage that can really scale," said Kaplan. "They have some revenue, but they need a lot of money to grow."
Venture capitalists are known for investing in technology companies, but they also make bets on businesses in other industries – granted the business has the potential to be huge. [Read related article: Differences Between an Angel Investor and a Venture Capitalist]
What are the pros and cons of VC investments?
Venture capital can be extremely helpful for taking your business to the next level. A venture capital investor often serves as a mentor, guiding your startup as it expands. They also tend to have a lot of contacts, helping you network with the right players. A major boon of this type of financing is that there's no obligation to pay any of the money back.
That's not to say there are no downsides to venture funding. The main one is the difficulty of raising capital – a challenge that has worsened during the COVID-19 pandemic.
"They are really looking for the needle in the haystack," said Kaplan of venture capitalists. "They fund very few companies." If the business isn't disrupting a market and can't get to the $50 million in revenue mark in five years, he said, then VCs won't be interested.
[PE or VC investing not for you? Check out our picks for the best small business loans to find more financing options.]
What are the main differences between PE and VC funding?
There are several differences between private equity and venture capital funding:
- Private equity is for business owners who are willing to give up majority control of their operations. VC investors are only interested in a minority stake.
- There are more private equity firms than venture capitalists, which makes raising capital easier for businesses. A PE firm casts a wider net, investing in all sorts of industries. A VC firm is only interested in startups that have the potential to disrupt a market.
- Both PE and VC investors bring knowledge and expertise to the equation, but PEs are looking for a quicker turnaround on their investment than a venture capitalist, who is willing to wait for the payout.
- PE and VC firms invest in different sizes of businesses. Private equity firms won't touch a company that doesn't have any sales, but a VC firm will. VC investing tends to be risker, since the company is just starting out.
- While both types of firms invest in a wide range of different companies and industries, VC firms are far more interested in niche business models. VCs are particularly interested in tech startups. PEs like predictability, and they tend to favor businesses in established markets.
- Perhaps the biggest difference between PEs and VCs is risk tolerance. Venture capitalism is built on the idea of taking risks to make money. PEs are very risk-averse and will only invest in companies that have established proof of their ability to make money.
- The size of the business also distinguishes VCs and PEs. PEs favor businesses that have already shown a reliable growth model. VCs often invest in businesses that have yet to make any money. Because of these differences, venture capitalists more often invest in small businesses, while PEs will invest in medium or larger companies.
- A private equity investment almost always comes with a change of leadership. This means that operations are also likely to be overhauled. Venture capitalist investments do not come with a change in control of the business. While VC investors might offer compelling advice, operational overhauls are less common.
- Another major difference is the concept of emerging markets. PEs rarely acknowledge emerging markets. Instead, they want more control over saturated markets. VCs are constantly searching to forge the next emerging market. It is a higher-risk, higher-reward strategy.
Despite these differences, a company seeking alternative investors should look for the same attributes from the private equity companies or venture capital firms they work with. That means partnering with someone who knows the business and genuinely wants to help.
"If you get money from somebody who doesn't understand the business, that's dumb money," said Kaplan. "That is not going to help you."