Private equity and Venture capital

Venture capital (VC) and private equity (PE) are two terms which often overlap in practice, so the distinction between these goes un-noticed. The purpose of this post is to lay down how both the terms differ.

Private equity is usually about taking an existing company with existing products and existing cash flows (positive or negative depending on the industry, products, strength of management team, prospective markets etc), then restructuring that company to optimize its financial performance.  When private equity works right, it can save poorly performing companies from cash crunch and turn them into profitable enterprises thereby avoiding them from becoming bankrupt.

A Private equity firm wants the companies in its portfolio to continue to grow, so it may add on other synergistic acquisitions and then sell the company to another firm within a few years. Although enormous growth rates are usually desirable, most PE firms are realistic and don’t expect their portfolio companies to grow by quantum leaps. They aren’t seeking exponential growth but rather good, solid geometric growth.

Venture capital is investing in financially viable start up ideas which are backed up by technical brains behind the ideas. This involves funding the persons generating the ideas so as to enable them turn these ideas into realities which generate cash. Venture capitalists invest small amounts of money in dozens of companies. Funding these ideas involves high risk. Also, the funding is required generally at very early stages of product development.

A Venture capital involves betting the start-up which will rapidly bloom into an enormous company (eBay, Microsoft, Sun, Google, and Apple are all examples of venture funded start-ups). The Venture capitalists expect their investments to increase with exponential growth. At the same time, the venture capitalists also run a great risk of failure of the start ups which were earlier funded by them. [As per the historical data, most of the start-ups shut their shops within 5 years from the commencement of business...!].

Apart from the above basic approach differences between PE and VC, the following areas also does matter:

§    PE firms buy companies across all industries, whereas VCs are focused on technology, bio-tech, and clean-tech and simply said emerging areas [New area is the education industry where the investment by VC is growing in India].

§  PE firms mostly buy 100% of a company in an LBO, whereas VCs generally acquire a minority stake – less than 50% [The balance is held by the founders/promoters].

§  PE firms make large investments in various large companies. VC investments are much smaller (since the investments in start-ups generally don’t require huge outlay as the funding is based on the ideas).

§    VC firms use only equity whereas PE firms use a combination of equity and debt.

§  PE firms buy mature companies with products known in the public and which have potential to grow whereas VCs invest mostly in early-stage – sometimes pre-revenue – companies (funding of financially viable ideas which may take considerable time).