Private equity vs venture capital: a comprehensive guide
By Indeed Editorial Team
Published 5 June 2022
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
Businesses can obtain finance to help them grow and diversify in a variety of ways. Perhaps the two most common forms of funding are private equity and venture capital. Businesses choose their funding according to their needs and preferred mode of repayment, amongst other factors. In this article, we take a look at the core components and differences between private equity vs. venture capital and the considerations for businesses when choosing between the two.
What is private equity vs venture capital?
If you're wondering what the differences between private equity vs. venture capital are, then you're not alone as many frequently conflate the two terms. Both describe specialist firms that invest in other businesses and then exit them. This could be by selling the investment (equity finance) or by holding an initial public offering (IPO). There are several key differences in the way these two types of funding entities conduct their business.
Venture capital and private equity businesses invest in companies of different sizes and types. They invest different amounts of funding and also take on different equity percentages in the firms that they invest in. Private equity firms invest in companies or entities that are not publicly traded or listed. Venture capital firms give funding to start-ups, scale-ups and other new and growing businesses with the potential to grow and offer an attractive return.
Private equity firms
Private equity firms buy ownership shares or interests in entities or businesses that are not publicly traded or listed. This private equity funding comes from high-net-worth firms and individuals who want to see an attractive return on their investment. The investors buy equity in private firms. They may also seek to gain financial control of public businesses, with the plan of running them privately and delisting them from the relevant stock exchange.
Large institutional investors effectively dominate the world of private equity. These include large private firms that receive funding and management from groups of accredited and high-net-worth investors and pension funds that invest on the behalf of their clients. The direct investment model of private equity means that substantial capital combines to meet the aims of the private equity firm. This explains why wealthy firms and individuals operate with this model.
Venture capital firms
Venture capital is a type of finance available to startups, scale-ups and small firms that can demonstrate their potential to grow fast and to offer high rates of return alongside fast growth. They often stand to achieve this by creating a new niche in the market or by innovating in their field. The investment for this type of finance is usually private. Wealthy private individuals, specialist VC funds and investment banks may be behind the funding. Alongside monetary funding, these individuals and bodies may also offer managerial and technical expertise to help these firms to grow and succeed.
In this instance, the investors essentially take on a considered gamble. They bet that the high-growth and high-potential young firm can deliver its goals and not fail. If they're right, they expect to receive high returns against their investment. Venture capital funding is popular amongst new businesses or those with less than two years in business. It's sometimes the only real option available to these firms, especially if they cannot access bank loans or capital market funding. Some businesses don't want to hand over equity and power to investors in return for funding.
Key differences between private equity vs venture capital
It's useful to compare the differences to see which suits a business or organisation better:
Private equity firms
Private equity firms usually:
buy established, mature firms that are often failing because they are inefficient in some way, with a view to investing in and improving the operation to grow revenues.
buy 100% of the business that they wish to invest in and take total control post-buy-out.
invest £100 million and upwards in a single business, thanks to their huge cash reserves.
prefer to focus their efforts on one business as they invest in mature and established businesses, which minimise the risks of absolute losses.
buy businesses in any industry and use both debt and cash to fund their investments.
combine the assets of various investors to buy an entire company or parts of it.
plan an exit strategy after a few years instead of seeking to maintain a long-term hold on ownership.
Venture capital firms
Venture capital firms usually:
invest in new or young businesses with high growth and high profits potential, seeking to obtain 50% or less of the business's equity.
prefer to invest in many companies rather than just one to diversify their risk.
spend under £10 million on each business, as startups have a higher chance of failure and can be unpredictable.
limit themselves to technology startups, clean technology, biotech and certain limited fields.
buy on an equity basis, investing in target businesses when they are new and performing well and taking on the risk of funding so that they can leverage the potential of the business and earn healthy profits.
give startups the funding to become targets for investment banking finance or private equity finance.
Related: What does a financial director do?
Why businesses need funding and the main types available
Businesses need finance for a variety of reasons. Depending on the business type and the industry that it operates in, it may be necessary for the owners to fund asset and materials purchases and employ people. They might need money to cover running costs, especially at the beginning. For example, these are all situations in which a business might look for funding:
To grow: An entrepreneur might look for seed capital to get a new venture off the ground. An existing firm might look for investment to grow its product offer or to invest in new machinery.
To finance capacity growth: Businesses may need new technology, equipment and capacity as they grow their offer and seek to remain competitive. As an example, technology can be expensive and the payback period may be some time, but the investment is usually necessary to improve the quality of goods, speed up production times and cut costs.
To develop and launch new products: Businesses want to stay relevant to changing customer needs, and firms research what their target audience wants and test new products in niche markets. This can be expensive and may require funding from external sources.
To export to or enter new markets: These objectives can involve significant costs for exporting, setting up logistics to new locations, entering into partnerships, creating new supply chains and investing in premises and staff.
To acquire another business: A business acquisition is usually a sizeable investment and is usually achieved through significant levels of private funding.
To move to new premises: Finance can help to pay relocation packages, to install new machinery and to make the new premises fit for purpose.
To pay daily running costs: Sometimes businesses have cash flow issues or find that they cannot meet unexpected bills. In these instances, finance can help to plug the cash flow gap and allow the business to meet its obligations.
Related: What are financial objectives?
Aspects to consider when applying for funding
Businesses can choose from a variety of funding sources to meet their needs. Decision-makers weigh up a series of unique factors to decide which type of finance to apply for.
Business owners or decision-makers consider the following:
The desired sum of money: Different finance sources meet different levels of financial need. Some sources only offer large sums and vice versa.
The speed of access: If the business can spend a while raising money it usually pays less interest for it. If it requires money very fast, such as in an emergency, it then typically pays a higher cost for more rapid access.
The cost of finance, calculated in terms of interest and fees: The cheapest form of business funding is through retained business profits, but many businesses prefer to maximise their reserves and cash flow rather than tie up profits in investment.
The risk profile: If the investment purpose is risky the finance model typically reflects this with a higher cost of borrowing. When businesses want to borrow for higher risk purposes they usually have to provide some kind of security as collateral.
The length of time: Short-term funding tends to be more expensive than long-term funding but this varies according to the nature of the project, the type of funding and the business's credit score.
The desired level of ownership: Whether or not they wish to hand over operational management and ownership to a funding body, as happens in the case of venture capitalist and private equity investment firms.
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