Venture Capital, Private Equity – What's the Difference?

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Alternative investments are big business, and they are gaining in popularity. Around $3.8 trillion in assets are under management in venture capital (VC) and private equity (PE), and a whopping $495 billion in aggregate capital raised. According to DarcMatter, some alternative investment funds have seen a 70 percent jump in participation over the past two years. It's no wonder. They provide a way for wealthy individuals to invest in unlisted and growing companies (big upside) while offering a source of funding for startups and mature companies that want to escape traditional financing structures.

While the terms "venture capital" and "private equity" are often lumped together as part of alternative investments, there are some significant differences. Whether you're looking to invest or are trying to find ways to raise capital for your own business, it's important that you understand these differences. 

Venture Capital vs. Private Equity

Venture capital and private equity do have some overlap, but they are fundamentally different. “I consider private equity and venture capital as opposites,” says former CEO of CUNO, Mark Kachur. “In private equity, you start with the numbers, and then you try to fit everything into the numbers. In venture capital, you start with people, and then you try to figure out what numbers you can make.” Usually, this means a company that already has existing cash flows is going to be more attractive to a private equity investor, while venture capital starts with an idea or product that is untested. Also, PE investing is often done as a firm and on a much larger scale.

Company Life-Cycle Stage

Private equity investors tend to look for mature companies that need a change. The company already has some good things going for it, but it needs restructuring to optimize the gains it realizes from those activities. For example, an established company that is facing bankruptcy because its management didn’t handle its cash well could be a profitable investment for a PE investor. 

In contrast, a VC investor is looking for the next big thing. Tech is a common industry for VC. This is Apple in 1977 when it was just the idea of two crazy guys. The environment is often utter chaos, but the investors believe in the team and its vision and are willing to wait for a return on their investment.

Debt Structure 

In private equity, an investor puts down a certain sum in exchange for a percentage of ownership in the company and debt payments. Think of it like a struggling company taking out a loan and offering up some equity to sweeten the deal. It will need to make debt payments to the PE investors and give them stock or a percentage in the company. In venture capital, there is only equity. The company offers a VC investor a certain number of shares in exchange for a lump sum of money, like what you see on the television show Shark Tank.

Percentage of Ownership

PE investors can acquire up to 100 percent of the company and often do, in the case of a leveraged buy-out (LBO). Remember, their aim is to change the way the business operates, and to do that, they need to have a bit more control. VC investors, on the other hand, have less interest in actually running the venture, so they almost always receive a minority stake (less than 50 percent) for their investment.

Size of Investment

Because the percentage of ownership is different in VC and PE, the size of the investment is usually quite different too. With private equity investments, the amount generally starts at around $100 million and goes up from there, well into the billions for very large corporations. Venture capital investments are considerably smaller, normally topping out at less than $10 million. That’s not to say that you might not find a PE or VC investment that is much larger or smaller than these numbers — they do happen — but generally, this is what you should expect to see.

Investment Horizon

Private equity investors have a different focus than their venture capitalist counterparts, so they also have different investment horizons. PE investors are looking for some big changes in an established company. It takes time to do that. As such, most private equity investors stay with an investment for at least six years, and as long as 10 years. In contrast, VC investors want to make their money back ASAP. They generally wait four to seven years to exit their investments, usually at the IPO or some other milestone.

Risks of Investment

Putting money into alternative investments is always risky. Choose private equity, and you're going to find there is decent upside. PE investments are so large that if one totally failed, it could bankrupt the firm, so PE investors tend to choose sure bets that they can turn around completely or at least recoup their investments. 

Venture capitalists are the complete opposite. They expect some of their investments to fail. Fred Wilson of AVC, who is an investor in Etsy, says that out of two dozen or so investments in his VC fund, he expects one to be a home run and four or five to bring home decent returns. As many as 10 may fail, and the balance may be just a wash — and that’s okay. Diversification is the name of the game. For Wilson, as long as one does hit it big, he can still post excellent returns.