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Private equity and venture capital funding are both considered alternative investments, but there are significant differences between the two.
Private equity (PE) and venture capital (VC) are two ways business owners can receive a capital infusion to run or grow their enterprises. While both fall under the broad umbrella of alternative lending ― and many people use the terms interchangeably ― the two funding sources have significant differences.
Your business’s size, industry, life cycle stage and prospects dictate which alternative investment method makes sense for you. We’ll examine the specifics of private equity and venture capital and outline their differences to help business owners determine the right investment option for them.
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Private equity and venture capital target businesses at different stages, 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,” explained Zsuzsanna Fluck, director of the Center for Venture Capital, Private Equity and Entrepreneurial Finance at Michigan State University. “Private equity is more about middle-market companies that are relatively stable and more mature.”
Consider the following differences between private equity and venture capital funding:
Despite these differences, a company seeking alternative investors should look for the same attributes in the private equity or venture capital firms it works with. In other words, partner 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 Steven Neil Kaplan, professor of entrepreneurship and finance at the University of Chicago’s Polsky Center for Entrepreneurship and Innovation. “That is not going to help you.”
Private equity is an alternative investment where a private equity fund or investors directly invest in privately held companies. Institutional and retail investors provide the capital the business uses to buy new equipment or technology, pursue bolt-on acquisitions, pursue growth opportunities or improve business cash flow.
Private equity funds can come from various sources. However, equity firms are the most common sources, including the following:
Major companies have often been purchased through private equities and it’s a common occurrence on the show Shark Tank. It’s essential to distinguish between PE investments and publicly traded investments. Publicly traded companies can be purchased. However, it does not qualify as a PE unless it becomes private at the end of the deal.
A private equity fund is motivated to make investments in private companies for several reasons:
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,” explained Fluck. “They typically invest in companies with $100 million to $500 million or more and some middle-market companies that are below $100 million.”
Like any funding type, 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,” Kaplan noted. “You may not be running it as well as you can and they bring in the real expertise.”
PE negatives include the following:
Venture capital investing involves a group of investors or funds injecting cash into a business in exchange for minority stakes. Like private equity investors, venture capitalists invest in private companies.
Here are two examples to help you better understand venture capitalism:
Venture capitalists and venture capital funds invest in startup companies at different stages of the business life cycle. The three primary venture capital types are seed capital, early-stage capital and late-stage capital:
“Venture capital is for businesses in the earlier stage that can really scale,” Kaplan explained. “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 ― if the business has the potential to be huge.
Like other funding types, VC investments have pros and cons.
Upsides to VC capital include the following:
However, there’s a significant downside to VC capital. Raising VC capital is challenging ― and it’s only gotten more complicated since the COVID-19 pandemic. “[VCs] are really looking for the needle in the haystack,” Kaplan noted. “They fund very few companies.” If your business isn’t disrupting a market and can’t get to the $50 million in revenue mark in five years, VCs may not be interested.
Kimberlee Leonard contributed to this article. Source interviews were conducted for a previous version of this article.
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