Private equity (PE) and venture capital (VC) are terms that you hear commonly in the startup world. Broadly, both terms can be grouped under private capital (investment and funding available from private investors not available in public markets), but there are several key differences between private equity investment and venture capital funding. Understanding these differences and when you might need either funding source is vital for any founder looking to raise capital for their venture.
In this article, we unpack the differences between VC and PE and when you might consider either type of investment.
Understanding venture capital
Venture capital provides capital (or funding) to new and ambitious founders who may have trouble finding debt financing (i.e. a bank loan) or aren’t ready for a public offering of shares. Very early-stage VC investors provide funding via what is known as a ‘seed’ round to new companies where they foresee value and/or profitability. Founders gain more than capital from VC investment. The benefits may include mentoring, networking opportunities or even hands-on assistance in day-to-day operations.
There are also later-stage VC investors who prefer to invest in later-stage or rapidly growing and revenue-generating businesses. These VCs value growing businesses on their existing and projected metrics and business performance, rather than just on the strength of the intellectual property or idea the founder has (as they might for seed funding). However, many VCs do note that their investment can be weighted heavily on their belief in the management or founder team and their ability to execute on their vision, rather than purely on metrics.
What other characteristics are venture capitalists interested in? That depends on the collective experience, interests and chosen strategy of the VC firm. Historically, venture capital has been closely tied to tech startups, but VCs also invest in innovators in many other sectors – for example healthcare, retail and real estate. Their investment amount varies depending on sector trends and the valuation of the company.
Funding rounds summarised
VC firms are often categorised into three stages: Seed, early-stage and later-stage. Venture financing occurs in rounds titled Seed, Series A, Series B, Series C and so on.
Seed-stage startups are businesses that have not sold anything yet (pre-revenue) but have a proof of concept or a minimal viable product to entice seed-stage investment. They often use funding to acquire their first customers, develop their business plan, and prepare for the first equity round of funding, ‘Series A’.
Series A funding is suitable for early-stage companies in need of cash to bring their product to the masses. For these funded startups, VC investment can provide a trove of seasoned leaders and industry experts, each with their own invaluable network. Series A VC investors — like Airtree Ventures and Blackbird Ventures — want to inject fledgling budgets with significant amounts of capital in exchange for equity in the company.
With a significant portion of startups failing in their first five years of business, it is challenging to know which companies will succeed. As such, VC firms will spread out their investment across a portfolio of different sectors in the hope that one or more investments will result in a profitable exit and/or the coveted unicorn status — A billion-dollar valuation. Founders should not expect to give up a majority of their equity to gain investment from a VC, but should understand that at each funding round they may expect to give up 15 to 25 per cent of their remaining equity.
Series C round and beyond are for later stage businesses who have raised a Series A and B. As you move through the business lifecycle, your company will have a growing customer base, strive for profitability and attract more investors. At this stage, your company will need to expand quickly through aggressive marketing and sales activity, acquisition of competitors, hiring talent, developing new products or entering new markets.
Series C funds include private equity firms, institutional investors and late-stage venture capital. These investors want to back proven companies with a business model that is ready to scale. Private equity has some significant advantages that later-stage mid-sized businesses should consider.
Private equity maximises value
Private equity is a source of investment with different investment objectives and preferences, including target sizes (early-stage or middle-market), areas of expertise (transformation specialists), and styles (passive to controlling). These various types of PE houses share a goal of driving growth in a short period of time, thereby increasing the value of the company. Companies considering private equity to scale will need a PE investor that aligns with their particular market, stage, region and management style.
Suppose you are a mid-market company with room to grow, but some of your owners are ready to exit. You will need to consider how much capital you will need for this activity, which sources of investment (debt or equity) are available to you and — if equity makes sense — identify the PE house that fits your goals. Middle-market PE deals typically involve placing someone on your board and setting performance benchmarks in exchange for the required investment. To ensure alignment, owners must be clear on their objectives for seeking investment, what terms are non-negotiable and how they envision accelerating their plans for rapid growth. PE investors typically want to realise returns in three to five years.
Takeaways
The journey to profitability requires investment. Whether private equity or venture capital is right for your company will come down to three critical factors:
- What you (the founder) want to accomplish with your investment
- Identifying and attracting the best type of investor for your business goals and stage of business
- Access to resources and expertise to develop the best equity deal for both owners and investors.
BDO is a leading adviser to private equity and venture capital firms globally. Contact our advisers to learn more about how we support companies looking to accelerate their growth.