Private Equity vs Venture Capital: What's the difference?
Created on 26 Apr 2021
Wraps up in 5 Min
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Updated on 24 May 2022
The majority of you would have noticed the IPO rally in recent months. But going public is not as easy as you think. Firstly, it takes time. Secondly, companies have to comply with various laws, which make it all the more cumbersome. For startups eyeing to make their baby steps into the markets, it may to be an exactly viable solution. However, they may not have all the funds required to finance their startup either!
And that brings them to alternative sources of raising funds, the likes of PE & VC.
Private Equity and Venture Capital
The most popular methods of doing so are Private Equity and Venture Capital. In case you don't know about them, worry not. You will understand them effortlessly in this article.
As the name suggests, Private Equity means investing in private companies. They are investors who form limited liability partnerships for investing in companies not listed on a stock exchange. It is an easy and quick way for companies to raise funds for various purposes like expansion in investment, funding working capital, and other purposes.
Generally, they invest a substantial amount when other sources of funds are not available. And that too for a lengthy period. They charge a fee from management based on assets and profits. After all, the private equity firms have to survive themselves also, isn't it?
A unique feature is the extensive use of debt in a private equity firm. It leads to high leverage, which increases the return on equity. But it also increases the loss in case the target company fails. Everyone knows the higher the risk, the higher the returns. The vice versa is true as well. To earn higher returns, you have to take higher risks.
Private equity firms adopt several strategies, which are as follows:
- Distressed Funding: Here, the PE firms invest the money in troubled companies with underperforming businesses. The firm's objective is to turn them around by making necessary changes in the management or sell their assets for profits. In India, the government is an apt example of a private equity firm, considering the massive divestment in PSUs in recent years.
- Leveraged Buyouts: It is the most popular form of private equity funding. Here, the firm buys out a company entirely to improve its financial condition and resell it for profit to a third party or going public through an IPO. The process is the same as above, but the investment period is more in this case.
- Real Estate Private Equity: Here, the firms invest the funds in commercial real estate and Real Estate Investment Trusts. Hence, there is a comparatively higher capital requirement. Also, the lock-in period is more in this case.
Now that you know what Private Equity is, let's understand Venture Capital.
Remember one thing: it is a slightly tweaked form of private equity. It is the financing investors provide to startups and other companies having immense growth potential. Generally, investment banks, high net-worth individuals, and other financial institutions are venture capitalists. For instance, two weeks ago, you would have heard about the six startups which entered the unicorn community in just four days! Tiger Global was the reason behind this achievement, which is a venture capital firm.
Let's take an example. Assume that you invest in 20 startups. If even 2 of them were super successful, you can cover up the losses in others and get attractive returns. That is why they fund startups at the initial stages. This way, they can get a high stake in the startup at low valuations. It becomes a win-win situation for the entrepreneur and venture capitalist.
If you are an entrepreneur, you would want to know how to get funding through a venture capitalist. Worry not. We got you covered. The first step for a startup is to submit a business plan. How can you expect the investors to invest when they don't even know your business? If the investor is interested, they perform due diligence and analyse the business model and operations.
After the due diligence is complete, the investors invest in the startup in exchange for equity. What's more, there are different funding rounds classified as Series A, B, and C. After some years of investment, the investor exits the company and gets massive returns on investment (only if the startup survives till then).
Difference Between Private Equity and Venture Capital
If you think that private equity is the same as venture capital, you are not alone. But it's not your fault. The principal concept between them remains the same, i.e., they invest in companies and earn returns by exiting their investment. But there is a significant difference between them.
- Private Equity firms invest in private companies whose financial health has deteriorated. The investment is made in established and matured companies, whereas venture capitalists invest in startups and young businesses with future potential.
- Private equity is offered in monetary terms only. But VCs can offer investment in non-monetary terms as well. E.g., giving the required technology or managerial expertise, which increases the possibility of a startup becoming successful.
- Generally, private equity firms buy the entire stake in the investing company. On the other hand, venture capitalists don't acquire even the majority stake. If they become the owners, entrepreneurs may be discouraged from working in "other's" companies. That is why they take less than 50% stake.
- Private Equity firms concentrate on few companies as significant investment is required. But there is an enormous risk in the case of startups. So, the VCs try to diversify their risk by investing less in many startups. Because imagine investing all of their funds in a single startup. If the startup fails, nobody can save the VC from getting bankrupt.
- The former firms are not restricted to any industry, as the companies are well established and matured. But VCs prefer investing in emerging industries like fintech, EdTech, etc., where there is immense potential to grow. After all, what will be the point of investing in startups where there is heavy competition already present?
Private Equity and Venture Capital invest in companies and get returns while exiting their investment. Although the core principle is the same, there are some differences between them. The main difference is that Private Equity firms invest in partly saturated companies, while Venture Capitalists invest in startups.
In the end, it would not be wrong to say that the success of new-age startups in the country is backed upon these PE/VC firms. And from the confidence these domestic and foreign players are exhibiting, one could say that the Indian startup space is doing a phenomenal job!
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