Venture Capital vs Private Equity

When discussing venture capital (VC) and private equity (PE), understanding the place of the public and private markets in the larger financial landscape is important. In the public market, companies sell shares to the public, who use the shares to earn interest. In the private market, shares in companies are not sold to the public. Professional investors invest in these companies and, in return, are given equity.  

Private equity and venture capital operate within the private markets. According to PitchBook, “the private markets control over a quarter of the US economy by amount of capital and 98% by number of companies”. So, it’s clear that PE and VC firms play a major role in the economy of the United States.

What do PE and VC firms do?

Both PE and VC firms invest in privately-owned companies by raising capital from individual investors of high net worth, known as limited partners (LPs). Both PE and VC firms want to support the companies they invest in to grow and prosper so they can sell them and make a handsome profit.

A closer look at private equity

Private equity refers to investment in companies that are not publicly listed. PE firms form partnerships of high-net-worth individuals who pool their financial resources for investment purposes. PE funds may buy private or public companies, but they don’t hold stakes in companies that remain listed on a stock exchange.

PE firms invest in established companies that may be experiencing adverse conditions, but still have growth potential. The aim is to help these companies succeed and then sell them at a profit.

It seems the most common equity investment type is a leveraged buyout (LBO).

Leveraged buyout explained

An LBO happens when a PE firm obtains a controlling stake in a company by combining equity and providing debt, which the company has to pay back at a later stage. The idea is for the PE firm to help the company turn around and make a profit.

A closer look at venture capital

Venture capital is raised by VC firms that consist of limited and general partners. The money is raised from the limited partners who pool their financial resources to back startups and emerging companies. A VC firm usually buys an equity stake in the venture, which they then support to succeed. The desired end outcome is a profitable exit in the form of an IPO or acquisition.

Differences between private equity and venture capital

While both PE and VC firms primarily invest in companies for profit, they differ from each other in significant ways, including the types of companies they invest in, the amounts they invest, and the percentage of equity acquired. Let’s look at some of these differences in more detail.

1. Type of company

PE and VC firms invest in different types of companies. Private equity firms invest across industries and may acquire companies involved in healthcare, agriculture, oil and gas, construction, manufacturing, transportation, and energy. 

VC firms have traditionally focused on tech companies, in particular the internet industry, computer hardware and software, mobile, and telecommunications. A lot of VC money has also gone to healthcare.

2. Company stage of development

VC firms typically invest in startups that have the potential for massive growth. VC funding can save struggling new ventures in their early stages, making it possible for them to take a promising product to market and scale production.

The VC firm Sequoia famously made a killing of $3 billion when Facebook acquired What’s App. Sequoia invested a mere $60 million in the instant messaging service over the years.

On the other hand, PE firms tend to buy well-established companies. These companies are typically in some sort of difficulty, which the PE firm estimates it can help to resolve. The aim is to create a turnaround and eventually sell the company at a profit.

3. Deal size

PE firms make bigger investments than VC firms. PE firms invest between $100 million and $10 billion. According to Investopedia, private equity firms typically look for investors who can invest $25 million. This threshold puts PE investments out of the reach of ordinary citizens.

In the early-stage funding rounds, VCs generally make smaller investments, which can be less than $10 million for early-stage companies. In 2019, the average Series A funding amount was $13 million.

Things are changing in the world of venture funding. The amounts that are being invested by VC firms and others who have entered the investment market have skyrocketed. Investopedia reports that VC firms invested a record $330 billion in 2021. The growth is being led by large and late-stage investments, with mega-deals of $100 million or more becoming more common.

4. Equity size

An obvious difference between PE and VC firms is that private equity firms usually purchase the entire company, while venture capitalists acquire a percentage stake in a startup or early-stage company. The VCs share equity in the companies they invest in with the founders and angel investors.

In cases where a private equity firm doesn’t get complete ownership, it will definitely obtain the majority share and therefore, control of the company.

5. Risk appetite

Venture capitalists take on a lot of risk. They know from experience that 90% of startups fail, but they protect themselves against this eventuality by investing relatively small amounts in many companies. They bet on the probability that at least one of them will hit the jackpot and that they will then see a worthwhile return on their investment.

The investment model they use works for them because it spreads the risk over several deals.

This investment model can’t work for private equity firms. PE firms invest in fewer companies, but each deal is usually huge – if any of those big deals fail, the sheer invested amount lost would sink the company. PE firms limit their risk by investing in mature companies fit for a turnaround.

6. Investment vehicle

VC firms simply provide capital to finance their investment. PE firms, on the other hand, use both capital and debt to fund their takeover of a company.

Private equity firms are not spooked by the debt they incur because they reason they have many years to transform the company and recover their investment. Venture capitalists don’t look at many years to recoup their investment. They want a quick return on their investment, so debt restructuring is out of the question for them.

7. Return on investment

Here’s the bottom line question: which one generates a higher return?

The short answer: both deliver below their target. Both private equity firms and venture capital firms target a 20% return. The reality is that they most often realize returns of 10% (of course, some exceptions apply).

Venture capitalists see most of their returns come from one or two top companies in their portfolio. Equity firms can expect to get returns from any company in their portfolio, not just the top ones.

8. Level of involvement

Private equity firms have earned a bad reputation in the industry due to past practices. In the past, private equity takeovers meant the end of the company, the loss of jobs, and huge debt. Basically, these firms dismantled the companies they gained control of and sold them off.

Things have changed for the better, however. These days, PE firms make every effort to improve and expand companies in their portfolio.

Venture capitalists tend to become involved with a startup from the first funding round, developing a bond with the founders and their team and being generally involved with the company. Many VCs become very involved in the operations of a startup, which can be good for the company or work against it. VCs’ involvement varies from startup to startup and founder to founder.

9. Daily work

The work at private equity firms is like working in investment banking. The workload is less, responsibilities revolve around performing company valuations, analyzing financial statements, doing due diligence, and liaising with lawyers, bankers, accountants, and other PE firms.

In contrast, working at a VC firm is less about numbers and more about relationships. VCs spend time cold-calling and speaking to different people. If you are a people person, comfortable with wheeling and dealing, being a VC might be a good option.

10. Earning potential

People normally earn a higher income working in private equity than in venture capital. The reason for this is obvious: private equity attracts astronomical amounts of money. That being said, VC associates earn about $150K, which is nothing to scoff at. In fact, that is the base salary for both PE and VC firms.

Venture capitalists have been known to make fortunes, but as we all know, that is a rare exception.

11. Office culture

The office culture in PE and VC firms differ in a number of aspects:

• They attract different professionals. People working in PE firms are mostly from pure finance backgrounds, while VCs can be any kind of professional, including technologists and former entrepreneurs.
• Different atmosphere. The atmosphere is more relaxed at VC firms due to the variety of people. The atmosphere at PE firms can be highly tense due to the high level of competition.
• They attract different personalities. Private equity tends to attract ambitious individuals who can be ruthless in their pursuit of the top spot.
• Different working hours. VC firms usually follow a normal workweek schedule, while people at private equity firms work long hours with little time for a private life.

12. Exit strategies

Private equity is a long-term undertaking that may only turn into millionaire status for professionals at the end of many years. Private equity professionals who get impatient with the prolonged process have several exit options open to them.

• They go to work for hedge funds where they can get a return on their investment in a shorter time.
• They switch to venture capital, where the financial rewards may not be comparable, but they join the exciting world of startups.
• They join one of their equity fund’s portfolio companies in a senior capacity, such as CFO, CEO, or Director of Business Development.

Alternatively, private equity professionals can launch their own funds.

For venture capitalists, there are the following exit strategies.

• Initial Public Offering (IPO). VCs get a return on their investment when they offer their shares to underwriters during an IPO.
• A merger or acquisition is a strong exit plan for startups, entrepreneurs, and VCs. The startup is sold to another company, combining resources and eliminating competition. A company acquired this way usually demands a high price with excellent ROI for VCs.
• Shares buyback. The company can decide to buy back stock from VC investors. In a buyback, investors receive their capital back and usually at more than the stock market price. 

The future of private markets

According to McKinsey, the private market is growing. It grew by $4 trillion in the decade up to 2019, while the number of active private equity firms more than doubled.  

Private markets have drawn more investors because they see the possibility of high returns. This means private companies no longer have to go public to raise funds, as they can apply for funds from investors pouring money into the private markets. Due to these developments, there has been an increase in the number of VC-backed startups and PE-backed companies in recent years, reports PitchBook, predicting that the private markets will continue to increase in value and opportunity.