Venture capital is a term that floats around often in the world of investors, especially high net worth investors. What exactly venture capital is, though, can be a little confusing. Some might confuse venture capital with private equity. This then blurs the lines between the similarities and differences of the two. In this blog, we want to clearly explain venture capital: what it is, how it is used, and why both investors and entrepreneurs take much interest in it. We also want to clearly explain private equity. In doing so, we’ll talk about how it differs from venture capital, and why investors might choose one over the other.
So, What is Venture Capital?
Essentially, venture capital is an investment tool used by wealthy individuals. Venture capital firms use funds from investors to fund startups that they believe have a high potential for long term growth. It sounds simple enough, but the ins and outs of how exactly the venture capital funding process happens can be a little complex.
It is important to note that venture capital funding is carried out by venture capital firms, or VC firms. VC firms raise money from investors which they then use to create venture funds. These firms use the funds to purchase equity in early stage companies.
Much of the funds from venture capital firms come from limited partners, or LPs. LPs are typically large institutional investors serving their clients’ interests. These can include universities, non profit organizations, or even wealthy individuals. Limited partners can manage tens of billions of dollars, and typically want to invest in diversified portfolios. Hence, this is why venture capital investments can be so appealing.
Time is important
Another important piece of information to know about venture capital funds is that they have a lifetime of ten years. This removes a certain level of accountability from venture capitalists. The time period is short enough that they do not necessarily have to demonstrate short term financial gains.
This brings us to another important point. What financial gains does the venture capital industry seek to achieve?
First, to put the nature of VC funding into perspective, it is relevant to note that over two-thirds of venture capital-backed startups fail. At first glance this may seem like a startling number. But it reveals how high risk venture capital investments really are.
So what returns does it take for VC firms to account for all those losses? Venture capitalists are typically looking for returns anywhere from ten to 100 times what they invested in a given company.
Risk and reward
There is a reason that venture capital investing typically attracts wealthy individuals and organizations – it is a very high risk, high reward investment. Many investors without a strong portfolio cannot afford to invest in venture capital firms. But if you are able to take the risk, it is generally worth it, because the reward could be enormous.
The idea of investing in startups has been around for several years now. Just think of all the wildly successful tech companies that started in places like Silicon Valley. As a result, much of venture capital investing is staying up to date on current trends and being able to read where the market is headed. So, if you invest in a firm that you believe has a grasp on these variables, you could be positioning yourself very well.
Why Are Investors Interested in Venture Capital?
This is all a general overview of what venture capital is and how it works. However, we still have a few loose ends to tie up.
- Why do startups seek venture capital funding?
- What role do venture capitalists play in the company’s operations?
- What happens after the ten years of VC funding runs out?
- How does VC funding differ from other investment types, such as angel investing and private equity?
We will review and discuss the answers to these questions below.
Why do startups take interest in venture capital funding?
Or for that matter, why are entrepreneurs interested in receiving it?
The simple answer is that the businesses that receive VC funds are typically so young or new that other more traditional funding methods are oftentimes not available. As a result, investors consider them risky investments at that stage.
Therefore, it is frequently the case that if a startup wants a significant amount of funding, seeking out venture capital money provides one of the best opportunities for those funds.
What role do venture capitalists play in the company’s operations?
Another benefit to involving a venture capital firm in your startup is the level of experience that comes with it. This brings another point we raised into play. This would be the question of what role venture capitalists play in a company’s operations.
When accepting a VC firm’s funds, companies are also often obligated to give the firm a portion of ownership as well. This way, they can influence the future of the company in which they have invested.
The investors involved in venture capital firms are highly trained professionals with ample experience. They are intimately familiar with the complex world of financing newly formed companies. This makes their guidance and experience highly valuable for entrepreneurs who may not have the same business savvy.
Another important reason that many startups look towards VC firms as funding sources is that they are under no obligation to repay the funds if their business ends up failing. They will, however, lose control of the business.
Of course, on the flip side of all this guidance and experience is that business owners must give up some significant decision making power when dealing with a VC firm. Many firms require an ownership stake of more than 50%. This means that the original owners will no longer have the final say in management decisions.
Being tied to venture capitalists can create some stress for many small businesses, as the expectations for both their stake in the company and the company’s success (or high returns) is high.
What happens after the ten years of VC funding runs out?
At the end of the ten years of venture capital investment in a company, the venture capitalists typically either sell their shares of the company back to the owner, or through an initial public offering (IPO). The goal being, of course, to make substantially more at their exit than they put in upon their entrance.
So in essence, we’ve covered the idea of the venture capital investment process. An experienced, wealthy VC firm purchases a share in an entrepreneur’s early stage business, and provides guidance to the business for a short period of time. They then inevitably exit the business with the help of an investment banker.
Venture capital funds can be a great option for businesses who aren’t able to access more typical funding sources. As such, they need higher level financing than sources such as family members and friends can provide.
How does VC funding differ from other investment types, such as angel investing?
We still have not discussed what sets venture capital investing apart from other forms of business investing, such as angel investing and private equity.
First, we will discuss the differences between angel investing and venture capital investing. And then we will provide an in depth review of how private equity works, how it is different than venture capital, and the benefits and drawbacks of each.
The most prominent distinction between venture capitalists and angel investors is that VC investments refer to investments funded by venture capital firms. Meanwhile, angel investments refer to investments funded by individuals, or angel investors.
Venture capital investing also involves significantly more wealth than angel investing. Venture capitalists will typically invest millions of dollars in startups. Angel investors rarely invest more than one million in a business.
Another area in which venture capital and angel investments differ is the stage of the business that they typically invest in. Angel investors usually invest in the “seed” stage of a business – this is a new business’ earliest stage, where it is oftentimes no more than an idea. This is why angel investors invest such a significantly smaller amount than venture capitalists; there is not as much to go off of, and oftentimes these investors are friends or family.
VC firms, on the other hand, usually come in startup, or early stage of a business. At this point the business will still have a lot to prove, but will at least have a business model and deliverables for potential investors to examine.
Private Equity
So where does private equity fit into this investment puzzle?
Let’s start with a definition: at its core, private equity refers to investments in shares of a company that are not publicly listed. The funds are typically provided by private equity firms, or individuals with high net worth.
Private equity firms will generally take control of public companies, which they will eventually turn private by removing company shares from the stock exchange. Some of the criteria that form distinctions between venture capital and angel investing also form distinctions between venture capital and private equity.
Numbers are important
Numbers play a big part when distinguishing these types of investing. Angel investments are typically under $1 million, and venture capital investments are typically between $1- $10 million. Private equity investments are substantially larger – generally ranging anywhere from $25 – $100 million. This considerably larger investment obviously creates a different tolerance for risk in private equity firms versus VC firms, which we will discuss more farther down.
We also discussed that angel investors come into companies during their seed stage. Meanwhile, venture capitalists come into companies during their startup, or early, stage.
Private equity firms, since they are investing so much more, typically wait until the mid to late stages of a business to invest. Private equity firms are generally only interested in businesses that have already proven themselves to be profitable. Thus, this makes the major investment in the business more informed and more likely to yield a higher return.
Less risk, more reward
This highlights a major fundamental difference between venture capital and private equity: the goal of venture capital is to discover new businesses, or startups, and essentially take a gamble on them. Venture capitalists go into this knowing that many of their gambles will be futile. Yet the investment can be well worth it for the few that deliver high returns.
Private equity firms are not interested in the gambling aspect. They typically take on only moderate risk with their investments.
Private equity investors are making extremely informed and calculated decisions. In order to yield the returns they want, private equity firms expect most of the companies they invest in to succeed. The opposite is true for venture capitalists. They expect most of their investments to fail, and rely on the few that succeed to yield high enough returns that they meet their margins.
This is not to say that private equity firms exclusively take on successful businesses, though. Businesses that are already well established and profitable may not need the help of private equity.
Private equity investors are generally looking for a certain niche of business to invest in. They are interested in companies that have already gone beyond generating revenue and developed profitable margins and stable cash flows. However, they might be experiencing current financial stress and, oftentimes, poor management.
The price of ownership
This brings us to another big difference between private equity and venture capital. As we stated earlier, venture capital firms will typically acquire shares in around 50% of the company they are investing in. Private equity firms, on the other hand, acquire the entire company.
The general goal of private equity firms is to perform a complete overhaul on these companies that have been profitable, but are experiencing some financial stress. Private equity firms are made up of highly skilled and trained professionals. They will work to restructure the company’s debt. At the same time, they’ll likely put in place new management to carry out revised and more efficient operational procedures.
It is not often that a struggling company gets the opportunity for a long term, large scale overhaul like this. Hence, it’s what makes the prospect of being taken over by private equity so appealing to many businesses.
Some mature companies have proven potential, but are in need of some serious changes. This gives them not many better options than the vast resources of a private equity firm.
It is worth noting that private equity deals can be so massive that they are funded by a combination of cash and debt. Meanwhile, venture capital funding is made up purely of cash. Both types of firms target the same internal rate of return (IRR), though – 20%. They just have vastly different ways of going about collecting that targeted amount.
Which Businesses Are Sought by Venture Capital vs Private Equity Investors?
We have not yet discussed the different types of businesses that may be targeted by – or may themselves target – venture capital firms versus private equity firms.
The phrase “venture capital” has become quite enmeshed with thoughts of Silicon Valley, and this certainly has merit to it. Venture capitalists typically do hone in on the tech industry when targeting businesses to invest in.
The main reason for this is the unprecedented rate at which the tech industry is booming. Successful venture capital investing is so much about what industries and niches are in vogue at the current moment. And thus, these have the potential to be explosive. And since, in recent years, no industry has fit that bill better than the tech industry, it has become the main focus for venture capitalists.
Private equity firms are not as beholden to the whims of the public, however. Since their main focus is the internal workings of the business, the sector that the business is in is not as important. Private equity firms typically invest in business all across the spectrum, anywhere from healthcare to construction.
More differences between venture capital vs private equity firms
Venture capital is generally considered more relationship driven, whereas private equity is more of an exact science, similar to investment banking.
While both types of firms require extreme business and financial acumen and experience, the specific skill sets vary greatly.
As mentioned above, venture capital investing is much more focused on finding the “diamond in the rough” and then working with them through the extreme early stages of their business. This can require a fair amount of interpersonal skills, as new business owners oftentimes do not know much about business or finances. This relationship will require many meetings and discussions with their VC firm and partners.
Private equity investing is less worried about the various people at play; since private equity firms take over the businesses that they work with, they do not have to offer the same level of management and education that venture capital firms do. Instead, they are in charge and all the financial and management decisions are up to them. They do not have to convince any other owners of anything; they simply have to make the numbers work (which is usually not so simple).
The trend continues for both venture capital and private equity
Both private equity and venture capital have seen increased popularity in recent years. According to CB Insights, the annual amount of capital invested worldwide increased almost thirteen-fold between 2010 and 2019. And this number rose above $160 billion.
And what’s more, extremely large investments (or mega rounds) increased almost three-fold just between 2016 and 2018. Private equity has had a record breaking past few years in its own right. In fact, the industry as a whole raised $3.7 trillion from 2014 to 2018.
Has 2020 Changed How Investors Look at Venture Capital vs Private Equity?
Many people are curious about how the coronavirus has impacted high net worth investment fields.
The venture capital field has definitely seen a bit of a short term downturn due to the impacts of COVID-19. According to CB Insights, March of 2020 saw a 22% year over year decline in venture capital deals in the United States. What’s more, fewer VC firms have invested in extremely early stage startups this year than in previous years.
But the good news for the venture capital market is that, by nature, it is fairly resistant to short term fluctuations and changes. Since venture capital investments are slightly long term, they don’t suffer so many blows from extreme short term ebbs and flows of the market. It isn’t too detrimental if a business they invest in takes a short downturn, as long as they make up for it by the end of their investment cycle.
Both the venture capital and private equity fields are so complex, this post barely scratches the surface. Many of our clients have some involvement in successful venture capital and private equity firms, and we ourselves have significant experience with both.
Whether you are an entrepreneur, a business owner with experience, or new to venture capital or private equity investing, we would be more than happy to discuss this with you. Investments like these come with a certain amount of risk (and high potential for reward), so we want to be certain that you have as much information as possible going into it.
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Sources:
https://www.newyorker.com/magazine/2020/01/27/
https://www.cbinsights.com/research/report/