As a founder without a background on Wall Street, it’s easy to get confused by financial terms like Primary and Secondary shares, or in this case, Private Equity and Venture Capital investors.
Private Equity is simply the overarching term for capital in alternative asset class investments not listed on a public exchange. This includes ownership in privately-held companies such as internet businesses. A Private Equity firm is a type of investor sometimes referred to as a “PE”.
Venture Capital is a subcategory to Private Equity, where the capital is allocated to early-stage ventures or “startups”. Hence, this alternative asset class typically has a higher risk associated with it. A venture capital firm is also a type of investor, which most commonly is referred to as a “VC”.
Aside from investing in private companies, both PEs and VCs also have a responsibility to create a return on their fund(s). These are typically made up of General Partners (GPs), who work for the firm and manage a fund’s investments, and Limited Partners (LPs), who provide capital to be invested by the firm. But where they differ is both in terms of investment target profiles and investor practises.
Private Equity firms come in different flavours and some of the subcategories include micro PEs and search funds. But let’s stick to traditional PE firms for now and compare them to Venture Capital firms. Perhaps the biggest differentiator between them and VCs is the businesses they invest in. Not in terms of industry sectors, as both are attracted to tech and internet companies, but rather the stage and type of business profiles.
VCs tend to invest in startups and early stage businesses with huge growth potential in a large market. A hallmark for their target companies is also unprofitability. To them profitability is a red flag as it suggests a business isn’t reinvesting its capital in growth (fast) enough. Traditionally, VCs serve a role of supplying starved founders with growth capital to realise an ambition of a unicorn status, i.e. a billion dollar valuation. That also speaks to the risk associated with their investments where only a few successful investments are needed to return the fund given the disproportionate relationship between ticket sizes and capital gains from unicorns.
PEs, on the other hand, will tend to invest in more established and proven businesses. To them, profitability is usually a must but they also invest in businesses with high revenues and small margins (typically with the aim to cut costs). Unlike VCs, they commonly have a size constraint in what they invest in, typically starting at around $5-10M. Above that threshold they tend to look for cash cows that defensibly dominate a subsector of an industry.
Because of these differences in scope, Private Equity and Venture Capital firms don’t really compete for the same businesses. Whereas VCs will tend to find high-risk, high-return early stage startups to invest in, PEs will look for high revenue/profit small, medium and large private companies. The case for founders considering taking money from one or the other will therefore determine in part by the stage of their business as well as their growth aspirations.
Both types of investors have holding periods of about 3-10 years, meaning that when they invest, they do so with the intention to exit said investment by liquifying their holdings within a decade or so. Unlike Venture Capitalists, PE firms will sometimes also acquire a business outright, either immediately or eventually. This makes them a lot more operationally capable than VCs in terms of running, growing, optimising and even advising a business. But when they instead buy a stake, it too can be quite different to how Venture Capital firms operate.
VCs will invest in future unicorn startups pretty much exclusively. And when they do, it is with the expectation that the founder will do everything in their power to reach that $1B valuation, also if it means killing the business on the way to reach that target. This makes it hard for founders who have taken VC money to convince their investors to settle for anything less even when they discover a path to profitability that doesn’t lead them into the promised land of rainbows and unicorns.
The strings attached to VC money are a consequence of their practises where a few winners have to return the losses of all the other portfolio companies that went under. Their preference is therefore to buy newly issued shares via primaries with money earmarked business growth, i.e. fuel for the rocket ship. This is except for later fundraising rounds where some VCs will participate in secondaries. This is also why VCs tend to demand certain rights along with their equity purchase to control their investment, e.g. by taking board seats to block founders from premature exits or prioritising profitability over growth.
PEs will look to invest in cash flow positive businesses that weren’t created yesterday. As mentioned, they will buy both minority or majority stakes but they will do so via primaries AND secondaries. That means founders can get different terms to the VC dichotomy of “grow or die” as money from PEs doesn’t have to be burned as engine fuel. Depending on the amount of equity transacted, the PE will take on a role appropriate to the size of their position. But more so than VCs perhaps, PEs will be able to offer founders support and complementary services. So if they for instance buy a minority stake, they will lend founders expertise where they can provide it, e.g. managerially or operationally.
The expectations of PEs to the founders in whose businesses they invest depends on the deal but are much less uniform to those of VCs. On a case-by-case basis, PEs will pass on a board seat and ask for profit distribution agreements to take part in the annual proceeds of a business. This is not to say PEs aren’t interested in having a say in their portfolio companies, or don’t seek traditional capital gains from equity growth, but just that they rarely have the same 1,000x demands for a business and are more likely to be satisfied with an exit <$1B.
Useful resources: Private Equity, Venture Capital, Primary vs Secondary shares, Micro PEs, Secondaries via VCs