Private Equity vs. Venture Capital: An Overview
Private equity is sometimes confused with venture capital because both refer to firms that invest in companies and exit by selling their investments in equity financing, for example, by holding initial public offerings (IPOs). However, there are significant differences in the way firms involved in the two types of funding conduct business.
Private equity and venture capital (VC) invest in different types and sizes of companies, commit different amounts of money, and claim different percentages of equity in the companies in which they invest.
Key Takeaways:
- Private equity is capital invested in a company or other entity that is not publicly listed or traded.
- Venture capital is funding given to startups or other young businesses that show potential for long-term growth.
- Private equity and venture capital buy different types of companies, invest different amounts of money, and claim different amounts of equity in the companies in which they invest.
Private Equity
Private equity, at its most basic, is equity—shares representing ownership of, or an interest in, an entity—that is not publicly listed or traded. Private equity is a source of investment capital from high-net-worth individualsand firms. These investors buy shares of private companies—or gain control of public companies with the intention of taking them private and ultimately delisting them from public stock exchanges.
Large institutional investors dominate the private equity world, including pension funds and large private equity firms funded by a group ofaccredited investors.
Because the goal is a direct investment in a company, substantial capital is needed, which is why high net worth individuals and firms with deep pockets are involved.
Venture Capital
Venture capital is financing given to startupcompanies and small businesses that are seen as having the potential to generate high rates of growth and above-average returns, often fueled by innovation or by carving out a new industry niche.The funding for this type of financing usually comes from wealthy investors, investment banks, and specialized VC funds. The investment does not have to be financial, but can also be offered via technical or managerial expertise.
Investors providing funds are gambling that the newer company will deliver and will not deteriorate. However, the tradeoff is potentially above-average returns if the company delivers on its potential.
For newer companies or those with a short operating history—two years or less—venture capital funding is both popular and sometimes necessary for raising capital. This is particularly the case if the company does not have access tocapital markets, bank loans, or other debt instruments. A downside for the fledgling company is that the investors often obtain equityin the company and, therefore, a voice in company decisions.
Key Differences
A private equity firm's strategy is to buy mostly buy mature companies that are already established. The companies may be deteriorating or failing to make the profits they should due to inefficiency. Private equity firms buy these companies and streamline operations to increase revenues. Venture capital firms, on the other hand, mostly invest in startups with high growth potential.
Private equity firms mostly buy 100% ownership of the companies in which they invest. As a result, the firm is in total control of the companies after the buyout. Venture capital firms invest in 50% or less of the equity of the companies. Most venture capital firms prefer to spread out their risk and invest in many different companies. If one startup fails, the entire fund in the venture capital firm is not affected substantially.
Private equity firms usually invest $100 million and up in a single company. These firms prefer to concentrate all their efforts on a single company since they invest in already established and mature companies. The chances of absolute losses from such an investment are minimal. Venture capitalists typically spend $10 million or less on each company since they mostly deal with startups with unpredictable chances of failure or success.
Special Considerations
Private equity firms can buy companies from any industry while venture capital firms tend to focus on startups in technology, biotechnology, and clean technology—although not necessarily. Private equity firms also use both cash and debt in their investment, whereas venture capital firms deal with equity only. These observations are common cases. However, there are exceptions to every rule; a firm may act out of the norm compared to its competitors.
Advisor Insight
Rebecca Dawson
President, Dawson Financial, Los Angeles, CA
With private equity, multiple investors’ assets are combined, and these pooled resources are used to acquire parts of a company, or even an entire company. Private equity firms do not maintain ownership for the long term, but rather prepare an exit strategy after several years. Basically, they seek to improve upon an acquired business and then sell it for a profit.
A venture capital firm, on the other hand, invests in a company during its earliest stages of operation. It takes on the risk of providing new businesses with funding so that they can begin producing and earning profits. It is often the startup money provided by venture capitalists that gives new businesses the means to become attractive to private equity buyers or eligible for investment banking services.
Correction—Dec. 2, 2022: A previous version of this article wrongly stated that venture capital firms are limited to startups in technology, biotechnology, and clean technology. In fact, VC firms can work with a broader range of companies and sectors.
