Understanding the Difference Between Private Equity & Venture Capital Firms

Late-stage business owners often talk to our team about Venture Capital (VC) firms having interest in acquiring their companies. At the same time, start-up businesses talk to us about seeking investments from Private Equity (PE) firms.

If you’re a business owner and you’re looking to raise capital and/or sell your company – who should you be talking to? It’s important to understand the key distinctions between the two types of firms in order to save yourself time and to maximize the value of your relationships. Here’s what you need to know:

Investment Thesis

PE firms focus on mature companies … typically five-plus years in business with proven cash flow. While these companies are typically firmly established, they may be deteriorating or not making the profits they should be. PE firms provide working capital that is often used to fund new product or service line development or enable organic expansion. To the same extent, they will likely be seeking add-on acquisitions of other complimentary businesses in their space.

VC firms mainly invest in smaller start-up operations that have a high-growth potential. As a result, VC firms are typically industry-focused and function in the technology, biotech, healthcare, and cleantech industries. In general, VC firms tend to invest in riskier businesses than a traditional bank or PE fund is willing to take on. This type of thesis is more apt to generate home runs or strike-outs versus the PE model, which is somewhere in the middle.

Investment Risk and Percentage

PE firms invest in already established companies, often buying a 100 percent ownership stake. Since they take total control, their risk of absolute loss is minimal.

VC firms focus on early-stage and start-up companies. On the opposite side of the spectrum from PE firms, VC firms typically make smaller investments across many start-ups, diversifying their risk. Start-ups do not have the track record of success that established companies have and these are riskier investments. It’s likely that most of the companies in the portfolio may fail, but if one company becomes “the next big thing,” they could still earn significant returns, thus making the risk favorable. PE firms can’t afford that level of risk – one failed company could doom an entire fund.

Value Creation

Both firm types aim to earn returns above those of public markets yet do so differently. VC firms rely on the growth from their investment and companies for their own valuations to increase. Without some financial growth from their start-up investments, VC firms won’t yield any returns.

PE firms have the upper hand in creating more value through “financial engineering,” involving multiple expansions, debt pay-down, and cash generation. Again, because these companies have turned a profit already in the past, it is expected that they should be able to increase their earnings into the future, under the tutelage of an experienced PE firm.

Our team specializes in working closely with middle market PE firms. If you are looking understand how you or your firm fit into the private capital matrix, contact us today.