Money is money isn’t it? Does it matter where your money comes from? When it comes to considering Private Equity and Venture capital then YES! The difference is huge.
When reporting on investors, journalists tend to merge the two. Blogs like Techcrunch tend to use the word investor generically whilst actually predominantly talking about venture capital investors. That’s one of the key ways that entrepreneurs misunderstand how private equity works and what it is like running a PE backed business
Here are five ways that private equity investment differs from venture capital investment.
Five ways that private equity is different from venture capital
There are exceptions to all rules but the following five differences are correct in most to almost all cases. There are different types of private equity and I’m talking here about lower mid-market, growth private equity funds, ie those that invest in growing businesses by backing entrepreneurs,
Money flow: PE money goes to shareholders, VC money goes to the company.
When a PE firm invests in your business, the money they invest goes into the bank accounts of the shareholders, not the bank account of the business.
When a Venture Capital fund invests in your business, the money typically goes only into the bank account of the company. Sometimes, in more mature businesses, the founders may “take some money out” as part of the deal but this is less common.
So when PE invests in a business it would actually, perhaps, be more accurate to say that a PE firm has bought a business. Or at least bought a stake in the business.
This distinction is hugely important to entrepreneurs and it means that entrepreneurs use these two sources of money at completely different phases of business life :
- Venture Capital money is used when you want to start a business or take a business that you started with angel or seed money to the next level. Without it your business will fail as you are not cash generative yet.
- Private Equity money is used when you have been running a successful business for some time. You’re generating profits and cash and you want to de-risk your personal life by selling a partial stake in your business.
Selling to PE means you can take money “off the table” whilst still running and being in control of your business for the next phase of growth, assuming thats what you want.
Maturity: PE buys profitable, cash generative businesses whereas VC funds invest in startup, early stage, sub scale and non profitable businesses.
VC funds most often invest in companies that are pre-revenue (have no sales), pre-profit and don’t generate cash. Investors in seed rounds will invest in nothing more than a slide deck and a smiling management team – no product, no customers, nothing. You’d never get private equity firms doing that.
Private equity typically invests in companies that have established products, have shown product-market fit, are profitable and generating cash.
Lower mid-market private equity, where I work, typically invests in companies that are growing, generating at least £1million of EBITDA and are throwing off a similar amount of cash each year.
Cash generation is important for private equity as most PE deals are leveraged buy-outs. Leverage is a key way that PE firms increase their returns for investors whilst minimising risk. VC firms can’t use leverage as banks don’t lend to companies that aren’t reliably generating cash,.
Risk: PE funds expect few to none of their investments to fail. VC funds expect most of their investment to fail.
Ambition: PE is generally looking to make three times their money as a return in 4-5 years. VC funds are hoping to make 10 to 100 times their money.
Intervention: PE funds generally
Co-investment appetite: PE firms generally invest solo, VC funds commonly invest in packs.