Private Equity vs. Venture Capital: Pros, Cons and Differences
By Indeed Editorial Team
Published 18 June 2022
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
When companies want to raise capital, two of the ways they get funding from investors are through private equity and venture capital. Many people use these two types of funding interchangeably, but they have key differences in the type of businesses they support, the scale of investment they provide and the amount of equity they request from companies. If you're looking to work in any of these investment outfits, it's important to know about these financial instruments to determine the one that's most suitable for your career and personal goals.
In this article, we define what private equity and venture capital are, discuss their major differences and highlight the pros and cons of each one of them.
Understanding private equity vs. venture capital
When companies want to raise capital but don't want to go to the public stock market, they can choose between private equity vs. venture capital. These two investment sources are ideal for raising capital when a company is held privately. Before choosing any of these investment firms, it's important to understand how their funds can change the ownership structure of the recipient firm.
What is private equity?
Private equity is ownership in a company that is not listed on the stock market. This type of investment fund is an important way to raise finances for growth and expansion for privately held companies since such entities can't raise money from the public. Private equity funds typically come from high-net-worth individuals and institutional investors, such as hedge funds and other big investment firms. The goal of many private equity investments is to gain a majority stake in a company, improve the firm and then sell it for a profit. This means such investments require a large amount of capital.
Private equity firms pool these funds from wealthy individuals, accredited investors and institutional investors. These firms not only gather funds for investment, but they also help their clients choose companies with the potential for profitability and manage their investments across a wide range of assets.
Advantages of private equity
Private equity can provide several benefits to companies that can't raise capital on the stock market or take loans from traditional financiers. Here are some advantages of this asset class:
Increased growth potential
Private equity is a quick way to increase a company's working capital, increasing its potential for growth. More capital means the business can implement innovative ideas to generate higher cash flow, expand through mergers and acquisitions and perform ground-breaking research to enhance its leadership in the industry. Private equity is especially important for companies that are struggling or inefficient.
Private equity doesn't require companies to go through all the legal and regulatory requirements of raising capital from Initial Public Offers (IPOs) and other conventional financing instruments. It also doesn't involve convincing someone at a bank or other traditional lender that the business is going to repay a loan. The investment fund doesn't require the receiver to pay interest on the capital, allowing the company to dedicate the entire funds to improving its liquidity and speeding up the execution of its plans.
The availability of private equity investments can help a company try various growth strategies at different development stages. Different funding rounds from private equities can help a company turn an idea into a product, gain traction in a new market and solidify its position as a reliable solutions provider and prepare for an IPO and go public.
Instead of waiting on public investors who may only buy a few thousand units of shares, a company that receives private equity investment has minimal funding problems, making them more agile at implementation and finding out what works and strategies to discard for consistent growth.
Because private equity funds typically want to generate a high return on investment (ROI) for investors, they usually provide professional business guidance to companies that receive their funds. This is often the case if the private equity fund is investing in startups, small companies or struggling businesses. If the company is well-established and the management can achieve its goals, the investors may not interfere in the business's management.
High reward potential
Private equity can offer exceptional returns on investment for investors. This is because they give investors a large ownership stake in the business, which increases their profit when they sell the company. If a private equity fund can invest in a startup or struggling company at the right time, they can position themselves for above-average ROI if the receiving company succeeds.
Disadvantages of private equity
Despite the many benefits of private equity funds, they have downsides, which include:
Private equity investments are high risk for many reasons. They lack the regulatory oversights of traditional investment sources, and investors may not have total control over the receiver's management. A bad management team can cause investors to lose their money and a poorly executed product launch, and failure to assess the market before production can lead to unforeseen challenges. More dynamic competitors, technology obsolescence and many other factors can quickly change the momentum and viability of a company, even though the business showed positive prospects before receiving the investment.
High entry barrier
Private equity funds limit the number of people who can invest in promising startups and companies. Because the funds required for these investments are usually high, there's a natural barrier for retail investors to participate in these transactions. These investments are also usually complex and require long-term professional and institutional management, which limits them to the ultra-wealthy and large investment firms.
There's a dearth of transparency around private equity investment deals. Unlike raising capital from the stock market where businesses are required to publish their financial position and reveal any conflicts of interests, private equity investments happen out of public view. If investors don't perform adequate due diligence, it might be difficult to estimate the future performance of a company that's receiving capital. This places investors' funds at high risk, which makes it essential to perform thorough assessments and checks to verify a company's claims before giving them private equity capital.
What is venture capital?
Venture capital is a type of private equity for startups and other growth-stage companies. This type of investment provides capital for a startup or small business in return for ownership or equity, mostly less than 50% stake. The aim of venture capital is to buy stakes in companies when they're undervalued and sell them when the businesses grow at a profit. Venture capitalists can be individuals, groups and institutional investors.
Many entrepreneurs, especially in the technology industry, use venture capital to finance their seed and expansion stages. Venture capital isn't limited to cash infusions. The capital can be professional training through incubator programmes, marketing, office space, mentorship and other non-monetary support.
Advantages of venture capital
Here are some advantages of venture capital:
Industry-specific: Many venture capitals invest exclusively in specific industries or niches. For example, many venture capitalists focus on startups in tech, healthcare, transport and energy and other high-yield environments.
Reduced investment risks: Venture capital investments limit your liability to the amount you invest in an entity. Unlike partnerships and other traditional assets, investors don't face the risk of losing their belongings if the company they invest in fails.
Non-financial support: Venture capital provides new founders with valuable training required to manage their companies effectively. These companies take owners through mentorship programmes, networking events and other activities to enhance the success of their businesses.
Disadvantages of venture capital
Venture capital has some challenges, such as:
Reduced control: Venture capital makes investors co-owners of the business, which allows them to exercise control over its management. This can cause problems if there's a clash of interests between founders and investors.
High competition: In many startup ecosystems, there's a high level of competition for venture capital funding. If a company's business model and unique proposition aren't convincing enough, it might find it difficult to secure funding from venture capitalists.
Higher costs: In the long term, the cost of venture capital may be higher than the interest paid on traditional loans. This is because taking venture capital funding requires relinquishing some ownership and control to investors.
Differences between private equity vs. venture capital
Here are some differences between private equities and venture capital funds:
Recipient: Most venture capital firms invest in startups. Private equity firms invest in a wide range of businesses, including growth stage, established and struggling companies.
Level of control: Private equities often invest in companies to gain a controlling stake. Venture capitals often receive a minority stake in businesses as the funds required to invest is usually lower than that of private equities.
Focus: Venture capitals are typically less risk-tolerant, which makes them spread their investments across a wide range of high growth potential startups. Conversely, private equity companies prefer to focus on a single company that meets their requirements and provides the resources to make it succeed.
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