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).
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