Venture capital (VC) and Private equity (PE) are two major subsets of the private markets, a much larger and more complex part of the financial landscape.
Because the private markets control a quarter of the US economy in terms of capital and 98% in terms of number of companies, it is critical that anyone in any business capacity—from sales to operations—understands what they are and how they operate.
What is Venture Capital(VC)?
Venture capital is a form of private equity and a type of funding given by investors to startups and small companies that are considered to have long-term growth potential. Venture capital generally comes from well-off investors, investment banks, and other financial institutions.
However, it does not always take the form of money; it can also be provided in the form of technical or managerial expertise. Venture capital is typically allocated to small companies with exceptional growth potential or to companies that have grown rapidly and appear to be poised to continue to expand.
Venture Capital investment is also referred to as risk capital or patient venture capital because it entails the possibility of losing money if the venture is unsuccessful and it takes a medium to a long time for the investments to yield results.
Features of Venture Capital Investments
- Long term horizon
- Equity participation and capital gains
- Venture capital investments are made in innovative projects
- High Risk
- Suppliers of venture capital participate in the management of the company
- Lack of Liquidity
Examples of Venture Capital Firms
The venture capital firm has invested in companies like Uber, Bird, DoorDash, and 23andMe.
What is a venture capitalist?
Investors working with a venture capital company are called venture capitalists.
Not to be confused with an angel investor, a wealthy individual who is investing his own money in promising companies, a venture capitalist is raising and investing capital from limited partners. Mark Cuban and Lori Greiner, frequent investors in ABC’s Shark Tank, are examples of angel investors.
Methods of Venture Capital Financing
- Participating debentures
- Conditional loan
The Venture Capital Funding Process
In order to raise the money needed to invest in companies, venture capital firms open up a fund and ask limited partners for commitments. This process allows them to form a pool of money, which is then invested in promising private companies. The investments they make are typically in exchange for minority equity — which is 50% or less of the company’s shares.
When companies expand, they move through the various stages of venture capital. In addition, firms or investors may specifically focus on certain phases — which impact how they invest.
When a venture capitalist provides a fairly small amount of capital for an early-stage company to be used for product development, market research, or business plan growth, it is called a seed round.
As their name suggests, a seed round is often the first official funding round for the company. Convertible notes, equity, or preferred stock options are usually issued to seed round investors in return for their investment.
The early stage of the funding of venture capital is intended for companies in the development phase. This funding stage is typically greater in amount than the seed stage, because new companies require more capital to start operations until they have a viable product or service. Venture capital is invested by letters in rounds or series: Series A, Series B, Series C, and so on.
The later stage of venture capital investment is for more mature companies that may or may not yet be profitable but that have proven growth and generate revenue. As in the early stage, a letter designates each round or series.
When a company in which a VC firm has invested is acquired successfully or becomes public, the firm makes a profit and distributes returns to the limited partners that have invested in its fund. The company might also make a profit by selling some of its stock in what’s called the secondary market to another investor.
There are different exit options for Venture Capital to cash out their investment:
- Promoter buyback
- Mergers & Acquisitions
- Sale to another strategic investor
Advantages of Venture Capital
- A large amount of equity finance can be provided.
- They bring wealth and expertise to the company.
- The company does not have an obligation to repay the money.
- It provides valuable information, resources, and technical assistance to make a successful business.
Disadvantages of Venture Capital
- It’s a long and complex process.
- It’s an uncertain form of financing.
- The benefits of such financing can only be realized in the long run.
What is private equity?
Private equity (PE) is a type of financing in which money, or capital, is invested in a company. PE investments are typically made in mature businesses in traditional industries in exchange for equity, or a stake in the company.
PE is a significant subset of the private markets, a larger and more complex segment of the financial landscape.
Private equity, like real estate, venture capital, distressed securities, and other asset classes, is an alternative asset class. Alternative asset classes are considered less traditional equity investments, which means they are not as easily accessible in public markets as stocks and bonds.
What is a private equity firm?
A private equity firm is a type of investment firm. They invest in businesses with the intention of increasing their value over time before eventually selling the company for a profit. PE firms, like venture capital (VC) firms, use capital raised from limited partners (LPs) to invest in promising private companies.
Unlike venture capital firms, private equity firms frequently take a majority stake (50%or more) in the companies in which they invest. Private equity firms typically own a majority stake in multiple companies at the same time.
The collection of businesses that comprise a firm’s portfolio is referred to as its portfolio, and the businesses themselves are referred to as portfolio companies.
What is a private equity fund?
Private equity investors raise pools of capital from limited partners to form a fund, also known as a private equity fund, in order to invest in a company. They close the fund once they have met their fundraising goal and invest the capital in promising companies.
PE funds vs hedge funds
Both private equity funds and hedge funds are only available to accredited investors. However, the most significant distinctions between PE funds and hedge funds are fund structure and investment objectives.
Hedge funds typically operate in public markets, investing in publicly traded companies, whereas PE funds focus on private companies.
PE funds vs mutual funds
The primary difference between private equity funds and mutual funds are the sources of capital, the types of companies in which the fund invests, and the manner in which the firm collects fees.
PE funds raise capital from LPs, who are accredited, institutional investors, whereas mutual funds raise capital from everyday investors.
Mutual funds typically invest in publicly traded companies, whereas PE funds typically invest in private companies. Furthermore, mutual funds are only permitted to collect management fees, whereas PE funds are permitted to collect performance fees.
How do private equity firms make money?
Management and performance fees are collected by private equity funds. These can differ from fund to fund, but the 2-and-20 rule is typically followed.
- Management fees: Calculated as a percentage of assets under management (AUM), which is typically around 2%. These fees, which are incurred on a regular basis, are intended to cover daily expenses and overhead.
- Performance fees: Calculated as a percentage of investment profits, typically around 20%. These fees are intended to incentivize higher returns and are paid out to employees to recognize their accomplishments.
How does private equity work?
Private equity investors form funds by pools of capital from limited partners in order to invest in a company. When they reach their fundraising goal, they close the fund and invest the proceeds in promising companies.
PE investors may invest in a company that is stagnant or potentially distressed, but still shows signs of potential growth. Although investment structures vary, the most common deal type is a leveraged buyout, or LBO.
In a leveraged buyout, an investor buys a controlling stake in a company with a combination of equity and significant debt that must be repaid by the company. In the meantime, the investor works to increase profitability so that debt repayment becomes less of a financial burden for the company.
When a private equity firm sells one of its portfolio companies to another company or investor, the firm usually makes a profit and distributes the proceeds to the fund’s limited partners. Some private equity-backed companies may go public as well.
What’s the difference between private equity and venture capital?
Private equity refers to investments or ownership in private companies. It’s also a term for the private equity investment strategy. Venture capital investments are a type of PE investment that focuses on early-stage startups. So, venture capital is a type of private equity.
- Private equity firms frequently invest in mature businesses in traditional industries.
- PE investors typically take a majority stake (>50%) in promising companies using capital committed by LPs.
- When a private equity firm sells one of its portfolio companies to another company or investor, the profits are divided among the PE investors and the limited partners. Typically, investors receive 20% of the returns, while LPs receive 80%.
- In their seed round, venture capital firms frequently invest in tech-focused startups and other young companies.
- VC investors typically take a minority stake (50%) in the companies in which they invest using committed capital.
- Because the majority of these VC companies are not fully established or profitable, they can be risky investments—but with that risk comes the potential for large returns.
- If a VC company in which the firm has invested goes public or is acquired, or if some of its shares are sold to another investor on the secondary market, the firm profits.