Health warning : This is a generalisation, it’s accurate but there is no law about what you call or how you define your firm or company so you’ll find a few PE firms on the edge doing VC like deals and you might find one or two the other way round. But in general, en masse – this is how it works.
VC’s and PE firms specialise in different stages of business
Venture Capital funds typically invest in early, startup stage businesses. They often invest in “pre-revenue” firms that haven’t started selling to customers yet or “pre-profit” firms that are generating revenue from selling to customers but are not yet making profits.
Private equity funds typically invest in later stage companies. Some funds specialise in growth investments (and this is further split into “small cap” and “mid market“), some specialise in larger, more established businesses and a small handful specialise in turnarounds, where the business has gone wrong and will soon go bust.
But the real key difference is that it’s all about where the money goes.
Typically, in a VC deal all or most of the money they invest goes into the company – it gets paid into the company’s bank account and is used by the company to pay for future operating expenses that the investors hope will take the company on a growth plan and closer to future profits. The VC is given new shares in the company that the company issues – this dilutes existing shareholders by a proportional amount.
In a Private Equity deal, the PE firm is buying shares from existing shareholders, sometimes a founder or group of founders. The money the PE firm pays or “invests” in the business doesn’t actually go into the company’s bank account at all, it goes to pay existing shareholders who have sold their shares to the new investor. So the money goes into their bank accounts not the company’s. That’s one reason why PE deals tend to apply to companies that are already making a profit – the company doesn’t actually need the cash itself but the current owners want to “de-risk” their investment in the company by reducing their shareholding or selling all of it.
PE deals can help growing businesses accelerate by allowing the founder to sell some (typically half) of their holding in the company. This allows the founder to get cash “off the table” out of their company whilst still retaining ownership of it and being able to grow the business for everyone’s benefit. Many entrepreneurs talk about their ability to focus better on the needs of the business and its growth when they don’t worry that their whole financial future is completely tied up in the business.
The comms around this causes a muddle
Whilst clearly the money flow in VC deals and PE deals is very different, they nearly always get reported in the media in an identical way. regardless of where the money went, deals are almost always reported as “Investor invests in Company X in order to fuel growth in new products and markets”. A more accurate (but perhaps less practical) headline for a PE deal would be “Investor buys 51% of Company from founders, allowing them to pay their mortgages off and focus on doing the right thing for the business for the next 5 years”
Footnote on “turnaround specialists”
Note : Turnaround specialists are the exception in PE- they are often acquiring a business that is about to go bust so the shares have no or minimal value. When they acquire this business they will likely have to put money into the business just to keep the wheels turning for a short time so they can restructure it. The selling shareholders are often just relieved to be free of the liability and thats why you occasionally see businesses sold for £1 or $1. A surprising number of well known brands have fallen on hard times and have ended up in this category, including Barings Bank (sold to ING for £1), City Link Couriers (sold to Better Capital for £1), Furniture retailer MFI (sold to PE for £1), Chelsea Football Club (Sold to Ken Bates for £1) and both British Home Stores (BHS) and Readers Digest. There aren;t many turnaround specialists, truth be told as it’s a tricky gig catching a falling knife. Jon Moulton is the best known professional in that industry and key players include Alchemy Partners, Better Capital and Hilco who specialise in retail liquidations.