Venture Capital and Private Equity are two distinct forms of financial support utilised by businesses at various phases of development. Sometimes, they are grouped together owing to the conceptual resemblance that exists between them. Investment firms, such as private equity (PE) and venture capital (VC), seek money from investors known as limited partners (LPs) in order to make investments in privately owned enterprises. Their objectives are similar to each other, i.e. to increase the value of the companies in which they invest and then to sell their part for a profit when the time comes.
There is, however, a substantial distinction between how they achieve their objectives. Private Equity firms often acquire a majority stake, i.e. 50 percent or more, in mature businesses operating in established sectors. They often search for existing businesses that are suffering from some major issue, i.e. too many employees, operational inefficiencies, unaligned focus, etc, and have a foolproof system to eliminate it. The notion is that if such inefficiencies are eliminated, firms may either improve their business margins, or atleast become profitable. This, in turn, increases the valuation of the company. However, this nature of operation has taken a new direction, since PE firms are now acquiring more VC-backed technology businesses. In contrast, Venture Capital firms focus on investing and advising the startups. These young, often technology-focused enterprises are fast developing, and VC firms give money in return for a minority stake, i.e. less than 50% ownership.
In this article, we’ll go further in detail to distinguish between PE and VC.
Operating Structure
To obtain the capital necessary to invest in businesses, Venture Capital firms establish a fund and solicit commitments from limited partners. The VC firm uses these funds to invest in promising startups with strong growth potential. As the startup matures, they pass through many stages of growth, along with multiple rounds of funding. VC companies often specialise in one or two rounds of venture capital investing, which influences their investment strategy. If a Venture Capital firm invests in a business that is successfully purchased or goes public via the IPO process, the firm earns a profit and distributes profits to the fund’s limited partners. Additionally, the VC Firm may benefit by selling part of its shares to another investor on the secondary market.
In case of PE Firms, the fund manager(s) pool funds from Limited Partners to establish a fund, sometimes referred to as a Private Equity fund, and invest it in businesses with high growth potential. However, the businesses in which PE firms want to invest often appear quite different from the startups in which VC firms invest. To begin with, Private Equity investors may invest in a business that is stagnating or maybe troubled but yet has scope of growth. Though the Private Equity investment can take a variety of forms, the most frequent one is a leveraged buyout (LBO).
After making enough changes that sets the business in line with their objectives, the PE firm can either sell the business at higher valuation to an interested buyer, or maintain it in their portfolio for sharing dividends with LPs and exiting before the fund’s lifetime.
Both Venture Capital firms and Private Equity firms generate money by charging management and performance fees to investors in their respective funds. Management fees are generally calculated as a percentage of committed capital, with a company charging an LP 2 percent of committed money. Instead, performance fees are considered as a method to reward senior-level deal specialists with payments that vary in size but may amount to as much as 20 percent of an investment’s total profits in certain cases, according to the industry.
Key Differences
Private equity firms generally purchase mature businesses that are already established. The firms may be degrading or failing to produce the profits they should owing to inefficiencies. Private equity firms purchase these businesses and simplify processes to maximise profits. Venture capital companies, on the other hand, generally invest in businesses with strong growth potential.
Private equity firms generally acquire 100 percent or majority stake of the enterprises in which they invest. As a consequence, the business is in complete control of the enterprises following the takeover. Moreover, to achieve their business goals, they get involved in the day to day activities, i.e. trimming down the team size, automate simple tasks, recreate organisation structure, etc. This also means that they can’t manage many businesses at once, since they are heavily involved in execution.
However, Venture Capital firms prefer to acquire less than 50% of stake in the company. Moreover, they prefer to stay away from day to day operations and only get involved in critical decisions, while also guiding the founders to run their startups effectively. Most Venture Capital organisations seek to spread out their risk and invest in many different startups. If one company fails, the total money in the venture capital business is not impacted greatly.
Investments by Private Equity firms in a single enterprise regularly exceed $100 million. Due to the fact that they invest in already established and mature businesses, these organisations choose to concentrate all of their efforts on a single company. The possibility of suffering absolute losses from such an investment is relatively low. Venture Capitalists often spend $10 million or less in each company they invest in since they usually deal with startups with uncertain chances for success or failure.
Conclusion
While this article discusses the contrasts between Private Equity and Venture Capital, it does not investigate the parallels between the two types of investments. They may, on the other hand, be able to collaborate with one another in certain situations. Ultimately, capital is channelled via private markets and a series of financial transactions in order to reach its eventual destination. In the private markets, every time money exchanges hands, specialists give advice or carry out the transaction, ushering in a period of growth or transition for the business or companies that have taken part in the transaction. The transactions shown in the map to the right are a condensed version of what took place.
