As a founder without a background on Wall Street, it’s easy to get confused by financial terms like primaries and secondaries, or simply Private Equity and Venture Capital.
Private Equity is the overarching term for capital deployed 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 investments, where the capital is allocated to early-stage ventures or “startups”. Despite this fact, due to a distinctly higher risk-reward profile, it is typically referred to as a separate alternative asset class to Private Equity. 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 funds. 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 practices and company target profiles.
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 and/or that it has reached maturity.
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 power laws dictating the relationship between ticket sizes and capital gains from unicorns to cover the losses from all the fallen angels.
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 companies 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.
PEs will oftentimes acquire not just a minority stake but rather a majority stake or a business outright. Full acquisitions as a type of transaction where the controlling interest and transfer of ownership in a business naturally also lends itself better to businesses with existing product-market fit.
Because of these differences in scope, PE and VC firms don’t often compete for the same businesses. Whereas VCs will tend to find investment opportunities in high-risk, high-return early stage startups, 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 PEs and VCs 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, PEs will sometimes also acquire a business with intentions to hold it permanently. This is also known as permanent equity and focuses on dividend creation through cash flows.
This makes PEs much more operationally capable than VCs in terms of running, growing and optimising a business - or at least hiring a team that can. But when they instead buy a stake, it too can be quite different to how VCs 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 is best exemplified in Sam Altman’s (former president of Y Combinator) philosophy:
This makes it hard for founders who have taken VC funding 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 practices 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, or “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 or exist only as a powerpoint presentation.
As mentioned, PEs will acquire businesses as well as buy both minority or majority stakes. Sometimes this takes place through primaries but it more often than not tends to be through secondaries. That means founders get paid when they sell ownership. Additionally they can get different terms to the VC dichotomy of “grow or die” since money from PEs doesn’t have to be burned as engine fuel.
Depending on the amount of ownership bought/sold, 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.
For majority buyouts, PEs will sometimes keep founders onboard in a supporting role and buy them out fully down the road once the business has grown and/or been fully optimised. PEs will often buy and later sell the company/stake that they acquire unless they are in the permanent equity game. This is known as “flipping a business”.
The expectations PEs have to the owners of the business they buy a piece of 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.
In fact, to most PE firms, a 6, 7, or 8 digit exit is a good outcome for a business transaction assuming their invested capital returned double digit percentages. This is a stark contrast to most VCs who would consider anything below quadruple digit percentage returns a write-off.
Useful resources: Private Equity, Venture Capital, Primary vs Secondary shares, Micro PEs, Secondaries via VCs
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