On the surface, private equity and venture capital look quite similar. Both operate in the private market, and technically, venture capital is a subset of private equity. They are also structured almost identically. Both private equity and venture capital firms pool money from limited partners, and a general partner invests and manages that money. They even sound similar, using much of the same jargon. And when it comes down to it, their aim is the same at a basic level — raising funds from accredited investors to invest in private companies. All of these similarities aside, the two are traditionally quite different in the kinds of companies they invest in, how much they invest, the investment instrument, and more.
Private Equity (PE)
Oftentimes, PE firms will acquire controlling interest in a company through a leveraged buyout (LBO). Typically, this is done through the purchase of a combination of debt and equity that the company will eventually have to pay back. The aim then is to restructure and improve the company so that the firm can eventually make a profit. This can happen through the sale of the company or through a public offering.
PE investors are more risk-averse relative to VC investors, generally investing only in mature companies whose odds of failure are much less than that of an early-stage startup. PE investments are substantial, which is why PE investors invest in fewer companies. The failure of just one investment can have a catastrophic impact on the fund; therefore, PE investors tend to be very structured in their approach.
Level of Involvement
When a PE firm acquires a majority stake in a company, its intention is to improve it and flip it for a profit. As such, they tend to be highly involved in the function and performance of the companies they buy. Because they have the majority stake, they are able to make a significant impact on the operations of the company.
Venture Capital (VC)
Like PE companies, VCs also pool money from limited partners, oftentimes into a fund. That fund is then distributed across many early-stage startups chosen by the fund manager in exchange for equity. Over time, VCs may participate in additional rounds of funding for a startup, as it grows, sometimes co-investing with other VC firms. Unlike PE firms, VC firms do not aim to acquire the startups they’ve invested in.
VC firms make a profit when the companies they’ve invested in either get acquired or go public. In either event, the firm would distribute returns to the limited partners who invested in the fund. Another way a firm could make a profit is through the sale of company shares on the secondary market.
Venture investments are riskier by nature. VCs don’t expect every company they invest in will generate a return. Some will just break even, and many will fail, which is why they make smaller investments across a larger number of companies. By investing a little in many startups, the hope is that at least one will make it big, generating enough of a return to counteract inevitable losses.
Level of Involvement
How involved VCs get in the day to day operations of a startup it’s invested in can vary depending on where the startup is in its lifecycle, what the VC-entrepreneur relationship looks like, etc. Typically, VCs tend to be more heavily involved in the early, developmental stages of the startups they invest in, offering guidance, helping with hiring, making partnership connections, and offering general support. As the startup grows, this relationship will evolve, typically becoming less hands-on.
A Side-by-Side Look
Here is a simple way to visualize the major differences between the two. Of course, these are not set in stone and there will always be exceptions as the private market continues to evolve:
While PE and VC firms differ in their approach, the line between them can be hazy, as a company may take investments from both throughout its lifecycle as it grows from an early-stage startup into a mature, late-stage company.
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The information presented here is for general informational purposes only and is not intended to be, nor should it be construed or used as, comprehensive offering documentation for any security, investment, tax or legal advice, a recommendation, or an offer to sell, or a solicitation of an offer to buy, an interest, directly or indirectly, in any company. Investing in both early-stage and later-stage companies carries a high degree of risk. A loss of an investor’s entire investment is possible, and no profit may be realized. Investors should be aware that these types of investments are illiquid and should anticipate holding until an exit occurs.