It’s not uncommon for late-stage business owners to ask advisors if it’s possible to find a venture capital (VC) firm that might have an interest in acquiring their company. Nor is it uncommon for start-up businesses to ask advisors about possible investments from private equity (PE) firms.
Private investment experts reading this post will realize why those statements seem a bit odd. However, if you’re a business owner and you’re looking to raise capital and/or sell your company — don’t be afraid to admit if you don’t know exactly who you should be talking to. An investor is an investor, right? Who cares what they call themselves.
Well, it’s actually quite important to understand the distinction between VC and PE firms to save yourself time as well as to maximize the value of your relationships. The main two ways that these firms differ is in their investment thesis and desired level of risk. Here’s what you need to know.
Venture Capital Firms
VC firms mainly invest in smaller start-up operations that have high-growth potential. Each firm usually focuses their investment strategies on companies within one of three revenue stages: Seed-stage companies that have $0-1 million in revenue, early-stage companies that have $1-10 million in revenue and growth-stage companies that have $10-50 million in revenue.
Within a specific revenue stage, each VC firm will concentrate their investment strategy in a specific industry like technology, biotech, healthcare or cleantech. The typical investment structures that are used by VC firms within their desired investment thesis are equity and convertible debt.
Convertible debt is when a VC firm essentially gives a start-up company a low-interest loan that will transition into equity when the loan matures. This eliminates the need to come up with an arbitrary valuation for a new company in order to issue stock equity. It also is a way for new companies to obtain capital at a time when most banks won’t issue them a normal loan.
As you may imagine, this investment thesis lends itself to those who are willing to take on a higher risk portfolio. It’s likely that many of the companies a VC firm invests in may fail, but if one company becomes “the next big thing,” they could still earn significant returns, thus making the risk favorable. This model is much more apt to generate home runs or strike-outs versus the PE model, but is not quite as volatile as the angel investor thesis.
With this home-run mindset, VC firms tend to counter the inherent risk of their portfolios by making several small investments across many start-ups, thereby diluting risk through diversification. PE firms on the other hand can’t afford that level of risk — one failed company could doom an entire fund.
Private Equity Firms
PE firms focus on mature companies — typically five-plus years in business with proven cash flow. Some of the factors they’ll look for prior to investing are: Solid management teams, good customer base, high margins and strong balance sheets. In the end they want to put their money into businesses that are making money now and that will continue to make money for the next five to ten years with little changes in daily operations. They sometimes restrict their investment thesis by size and industry, but not often.
While PE firms focus on companies that are more firmly established than start-ups, they commonly invest when they believe that providing working capital to fund new product or service line development will result in expansion or when owners are looking to exit and the firm can easily sustain existing profits. To the same extent, they will likely be seeking add-on acquisitions of other complementary businesses in their space to build resource efficiencies and/or a shared customer base.
PE firms typically structure their investments through limited partnerships (LP) so that the firm gains the ability to directly influence the company as a general partner, but the actual investors are limited partners. The investment will have a maturation date, at which time the firm will sell the investment and return the principal and gains to the limited partners. They may also direct their strategy through a PE fund, which are much more stringent in their decision making, having high EBITDA requirements.
PE firms invest in already established companies, often buying a significant ownership stake. Since they take total control, their risk of absolute loss is minimal. However, because they tend to have a high-stake in each investment, one blunder can have a large effect on the firm’s returns.
Common Ground — Value Creation
Both firm types aim to earn returns above those of public markets yet do so differently. VC firms rely on the growth from their investment and companies for their own valuations to increase. Without some financial growth from their start-up investments, VC firms won’t yield any returns.
PE firms have the upper hand in creating more value through financial engineering, involving multiple expansions, debt pay-down and cash generation. Again, because these companies have turned a profit already in the past, it is expected that they should be able to increase their earnings into the future, under the tutelage of an experienced PE firm.
The value to you, the business owner, is that there are specific investment firms tailored to bring capital to your business and your unique situation. Whether you are getting ready to retire or on the verge of creating the next Facebook, you probably need funding. Knowing who to talk to, what they can offer and how they operate will save you quite a bit of time and effort.