Private equity (PE) can be used to refer to any investment in private companies. But the term generally refers to acquisitions of well-established companies. Such acquisitions are called buyouts.Venture capital refers to investments in new enterprises. But the term generally refers to investments made in the early stage or late stage. Angel investing refers to venture capital in the pre-seed or seed stage.
Private Equity
The chartered alternative investment analyst association divides the private equity asset class into four different categories:
Private equity is not a new concept. Almost every large company started as a small, privately-owned business. PE has a long investment horizon that needs endurance, foresight, and oversight.Private equity provides long-term capital for a business that does not have the track record to raise capital from the traditional capital markets and financial institutions. It finances both the long-term and short-term capital requirements of private enterprises.
The expected payouts of private equity investments resemble the payouts of long positions in out-of-the-money (OTM) calls. The risks are high, but the expected returns are much higher. The call option analogy of private equity concurs with the power law of returns, i.e., 80% of returns come from 20% of investments. This is especially true for VC.
Buyouts
In the context of private equity, the term buyout refers to a private entity acquiring a controlling interest in a company. It is also known as an acquisition. To secure a controlling interest a shareholder must acquire over 50% of the outstanding shares of the company. This will give the shareholder significant influence over the actions of a company Unlike in mergers, the acquired company operates as a stand-alone unit and is not integrated with the operations of the acquirer.
Acquisitions generally involve the use of leverage. There are generally three tranches of debt: senior secured, senior, and subordinated. These loans are underwritten based on the underlying free cash flow of the target company. In a leveraged buyout (LBO), the debt-to-equity ratio is much greater than before the acquisition. Leverage can be up to 9:1, i.e., 90% debt and 10% equity.
Types of Buyouts
Leveraged Buyout (LBO)
A leveraged buyout has three characteristics: an LBO takes a controlling interest, an LBO uses leverage, and an LBO itself is not publicly traded.
Management Buyout (MBO)
The buyout of a company by its current management team is called a management buyout.The controlling interest of the acquired company is concentrated in the hands of the current management and the buyout firm.
Management Buy-in (MBI)
The buyout is of a company led by an external management team.Control of the acquired company is taken over by the new management team.
Secondary Buyout
In a secondary buyout, a private equity firm sells a portfolio company to another PE firm. This type of buyout provides a secondary market for PE funds.
PE firms
Some of the most notable PE firms include KKR, Blackstone, EQT Partners, CVC Capital Partners, Thoma Bravo, The Carlyle Group, General Atlantic, Clearlake Capital, Hellman & Friedman, Insight Partners, Bain Capital, Goldman Sachs Capital Partners, Vista Equity Partners, Silver Lake, Warburg Pincus, Leonard Green & Partners, Clayton, Dubilier & Rice, Francisco Partners.
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Venture Capital
Venture capital (VC) is the most glamorous of private equity categories. It is early-stage to late-stage financing for nascent companies with the potential for rapid growth.Such companies do not have the track record to raise funds from traditional financial institutions and capital markets. Traditional institutions underwrite investments based on cash flow or collateral. Hence, they are unable to provide financing to startups as they do not have significant cash flow or collateral.
Startups have a high risk of failure and the equity in these firms are highly illiquid. Hence, VC is treated as an alternate investment and is handled by a separate class of financing institutions. The fundamental principle of VC is the underlying start-up businesses and the entrepreneurs who create and build them. These investors also provide access to their network which includes bankers, accountants, attorneys, mentors, and enterprise customers.
Types of Financing
Generally, financing takes the form of investment in the convertible securities of the enterprise. I.e., convertible preferred shares and convertible notes. Convertible preferred shares are senior to common stock in terms of voting rights and liquidation preferences. Preferred shares are converted to common stock before sale via an initial public offering (IPO). In the case of convertible notes, both the principal and interest amounts will be converted to either common or preferred shares. Conversion of securities is triggered by a liquidity event, i.e., the sale of the company, a priced round, or liquidation.
Broadly, there are three main ways to raise capital for a startup: SAFEs, convertible notes, and priced rounds.
SAFEs
SAFE is abbreviated as Simple Agreement for Future Equity. It is the most founder-friendly instrument to raise capital. It is comparable to a warrant. It gives the investor the right to purchase equity. The investor gives the entrepreneur money in the present without determining the value of the company and is allocated shares when a liquidity event is triggered.
Convertible notes
Convertible notes are similar to SAFEs with one exception, they accrue interest. The interest amount accrued is also converted to equity on the triggering of a liquidity event.
Priced rounds
The priced round involves the sale of shares at a predetermined valuation. The pre-money and post-money valuations are unique to the startup ecosystem. Investors who enter before the priced round through convertible bonds and SAFEs are allotted shares at a discount or a valuation cap. I.e., they receive more shares per dollar than the new investors.
Startup valuations
Post-money valuation = pre-money valuation + new money
The Pre-money valuation is the agreed-upon value of a company before raising new capital. The New money is the new capital raised by the company in the priced round. The post-money valuation is the valuation at which equity is allotted to new investors in the priced round.
Stages of Financing
VC has three stages: early stage, late stage, and pre-IPO.
First / Early stage capital
At this stage, the company has developed a minimum viable product (MVP), and the product has been beta tested. However, commercial viability is yet to be established. The business model is yet to be validated.
Second / Late stage / Expansion Capital
Commercial viability is established and capital is raised to scale up the company. The capital raised is used for distribution and marketing. The objective is to capture the largest possible market share.
Mezzanine / Pre-IPO / Bridge Financing
This is to keep the company from running out of cash before its IPO or sale to a strategic buyer. Capital may come in the form of convertible bonds or a traditional loan. The mezzanine capital is used as a stop-gap until accounts receivable is converted into cash, to cover the expenses of the IPO, and even to buy out earlier investors.
VC firms
Some of the largest firms in this industry in terms of assets under management (AUM) are Andreessen Horowitz, Sequoia Capital, Dragoneer, New Enterprise Associates, Deerfield Management, Khosla Ventures, Lightspeed Venture Partners, and Industry Ventures. Other notable firms include Plug and Play Tech Center, SOSV, Y Combinator, 10X Capital, Soma Capital, Alumni Ventures, Techstars, FJ Labs, and Global Founders Capital.
Angel / Seed Investing
An angel investor is an individual who provides capital to start a new business. An angel investor is typically a high-net-worth individual. But angel investment can come from friends and family as well. They are also known as seed investors, business angels, informal investors, angel funders, and private investors. They are informal investors as they invest their savings and do not pool capital into a fund. This distinguishes them from venture capitalists.
The origin of the term ‘angel’ comes from Broadway theater, it referred to wealthy individuals financed theatrical productions that would have otherwise not happened. Angels are often successful entrepreneurs and invest in industries in which they have expertise. With their experience, they can act as mentors to first-time entrepreneurs. They also fill the gap between friends and family, and venture capital funds
Angel Investing/ Pre-seed Capital
Angel investing is also known as pre-seed capital. It is the foremost stage of startup financing. Angel investors are investing in an entrepreneur’s idea. The entrepreneur does not have a business plan, management team, or a minimum viable product (MVP). The entrepreneur has not conducted market analysis and does not know if there is a demand for his idea. This is the riskiest investment that will ever be made in any enterprise. The amount of financing is minimal: $50,000 to $500,000.
The investment is made without a private placement memorandum (PPM) or subscription agreement. It can be as casual as an agreement written on a co*cktail napkin.Once the capital is raised, the startup founders must draft a business plan, develop a minimum viable product, conduct market analysis, and founding team members.Product testing and marketing are not started at this stage. The goal is to turn the idea into a prototype to attract venture capital funds.
Seed Capital
Although VC firms begin investing in the seed stage, not many VCs invest in the seed stage. Hence, entrepreneurs still rely on angels at this stage. The seed capital raised usually varies from $1 million to $5 million.
At this stage, the entrepreneur has drafted a formal business plan and recruited some founding team members. The product-market fit has not been validated. Once the capital is raised, the entrepreneur completes the development of a minimum viable product. The MVP is sent to prospective customers to get feedback and check for product-market fit.
Angel Investors
Some well-known angel investors include Peter Thiel, Marc Andreessen, Dave McClure, Tim Draper, Dave McClure, Chris Sacca, Reid Hoffman, Mike Maples, Fabrice Grinda, Reid Hoffman, Gary Vaynerchuk, Naval Ravikant, Marc Benioff, Mark Cuban, Scott Banister, Jeff Clavier, and Chamath Palihapitiya.
Key Differences
A business lifecycle has three phases: a start-up phase, a growth phase, mature phase. Each phase has its distinct capital requirements. PE buyouts and VCs operate on different parts of the business lifecycle. Angel investors and venture capitalists invest in startups, and PE funds target established companies with stable cash flows.
Angel and VC financing are essential in developing an MVP and validating the product-market fit. A buyout is necessary to unlist the company and focus on improving operations.
Startups have innovative, new technology that requires capital to achieve scale. The founder is idea-driven rather than operations driven. On day one, a startup is a faith-based enterprise. Annual recurring revenue is low and the burn rate is high. In contrast, PE buyout targets have a well-established product. The company focused on operational improvements and not new ideas. Annual recurring revenue is high and earnings are stable.
Pre-seed and seed capital investments are made in innovation and emerging technologies. PE buyouts are made with the potential for improving operating efficiencies and expanding product distribution.
Angels and VCs only seek a minority position in the company. Control is still in the hands of the founders. In contrast, a PE buyout seeks a controlling interest.
Venture capital and private equity firms have different internal rates of return (IRR) targets. Although both are quite high, VC hurdles are higher as the risk of investing in a new company with an unproven technology is greater than investing in an established company.
Private equity, venture capital, and angel investors take an active role on the board of directors of companies that they invest in.
