Money is money, isn’t it? Does it matter where your money comes from? When it comes to considering Private Equity (PE) and Venture Capital (VC) then yes! The difference is huge, explains Glenn Elliott.
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.
Remember, in this article, as in all articles on this site, when I say PE, I am talking is mid-market growth private equity, not turnaround specialists, special situations or the big evil affairs who buy non-growth assets and strip out costs.
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, i.e. those that invest in growing businesses by backing entrepreneurs.
1. Money flow: PE money goes to shareholders, and VC money goes to the company.
OK, this is the most important difference, so if you only read a bit of this article, read this bit.
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. Occasionally, in more mature VC-backed 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. But PE firms never like saying this (although it is true), so they will always say they have invested in a business (which is not technically true at all).
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 generating enough cash on your own to service and grow.
- Private equity money is used when you have been running a successful business for some time. You are 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 that’s what you want.
2. 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 pre-revenue companies (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 invests in companies that have established products, have shown product-market fit, are profitable and are reliably generating cash.
Lower mid-market private equity, where I work, typically invests in companies that are growing, generating at least £1million of EBITDA and generating 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.
3. Risk: PE funds expect few to none of their investments to fail. VC funds expect most of their investments to fail.
When a PE Firm raises a fund, it will typically spend that fund on nine or ten investments. It is rarely anymore. This is because ten has become the number that the industry has accepted as the optimum balance between three things:
- Spreading risk between assets. No fund wants to have too many of its eggs in one basket.
- Capacity to find and “do deals”. PE firms are generally small in terms of the number of investment executives, and they only have a certain amount of capacity to find and buy businesses.
- Capacity to “manage” companies they have bought. I use the term “manage” loosely, as PE firms do not generally actively manage their investments. Instead, they back management teams that they have assessed and trust to run the business. But they have to monitor the investment, be an active board member, occasionally nudge and suggest things, and if results are veering a bit off plan, they will have to get a little more involved.
So a PE firm can’t buy 20 assets from a fund as, whilst that would lower risk, it would also mean they would have to find 20 fantastic businesses rather than ten, which they just don’t have the resources to do. And the investment directors would have to sit on too many boards and get involved (lightly) in too many companies, so they would have even less time to find new businesses to invest in.
PE firms are buying companies that are already making money. That means they must have already found product-market fit, they must already have found a way to market to and sell to customers, and they have already found a way to make the product for less than they are selling it for. So when you compare that to a VC fund which is investing in startups, you can see that the risk profile is completely different. A VC might be investing in little more than a slide deck and an idea that hasn’t been market-tested yet, and they are backing a founding team that might not even have really worked together yet. So VC investing is a much higher risk.
Because VC investing is higher risk, they tend to invest in many more assets per fund as they need to spread their higher risk over more “bets”.
Out of a fund of 10 companies, PE firms expect one to do badly and only return its invested capital, eight or nine to do a respectable return of two or three times the money, and they hope that one will “pop” and make seven to eight times the money.
Comparably, a VC fund might expect half their companies to go bust, a bunch to muddle along not going far, and if they are lucky, one will make 100 times their money.
When you understand this different approach to risk, you will see why there is a corresponding difference in ambition.
4. 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.
Now you understand the risk difference between PE and VC funds, you can also understand the difference in ambition.
Because PE firms hope none of their assets will actually fail, they can have a sensible approach to growth. Most PE firms will target assets that have the ability to return two to three times the amount invested over a period of four to five years. This means that PE firms can invest in niche market leaders in markets that are big enough to give years of great returns but don’t need to change the world.
By contrast, VC firms need the chance to make huge returns from any one investment because most of their investments will fail. So that’s why some VC’s are always hunting for world-changing ideas that have addressable markets of billions. It means that VC’s can be unable and unwilling to invest in many niche markets that can contain loads of great high-growth businesses but not have the opportunity for world domination that the higher-risk VC model needs.
5. Co-investment appetite: PE firms generally invest solo, VC funds commonly invest in packs.
When a PE firm buys a business, they are buying a profitable, cash-generative business. This means that unless there is a dire emergency, that business will not generally have a need for “follow-on funding”. PE firms always keep some money back in their fund in case they want to help their portfolio company to make an acquisition, but that is generally the only common reason for an asset needing more money.
Sometimes, portfolio companies don’t need this money at all as they can do acquisitions and buy competitors or additional businesses out of their own cash flow.
VC investors, however, are investing in unprofitable businesses that are losing (burning) cash. Some may be “working capital negative” which means that when they win a client, they have to pay out money that they only recoup years later. These businesses burn more cash the faster they grow, and everyone just hopes the profits come eventually (often they do not, of course).
Because startups need constant topping up of money, they will have many “rounds” of investment. There is a whole set of names given to these, like Series A, Series B, Series C etc. Each round of investment will often have several investors and the bigger ones, such as those who “lead a round” (by investing a big chunk of the round’s total value), may get a seat at the board table.
This means that in VC investing, it is not uncommon for a company to have several competing VC investors, maybe from multiple rounds, all with a voice at board level. Sometimes these are harmonious, sometimes they have different styles and can be in conflict about direction or growth issues.
In PE, it is very rare to have more than one investor at a time. But it is perfectly normal to sell from one PE investor to another, which is called a secondary buyout.
If you followed all of that, you will now know there is a world of difference between Private Equity and VC Investors. Because the models are so different, you never see a process where PE is bidding against VC. Companies don’t really even get to choose – you are either attractive to PE, or you are attractive to VC, or maybe neither. In which case, you’re down to the Three F’s: Friends, Families and Fools.