Private Equity vs. Venture Capital: What founders need to know
If you’re a start-up in need of a cash influx, you may be wondering what type of fundraising dollars to pursue. We can help.Do you need to raise capital for your business? If you’ve moved beyond money from friends and family and other angel investing rounds, you’re likely deciding between private equity vs. venture capital for your next cash injection.
Knowing the difference between the two will help you understand what types of firms to pitch, how to pitch the targeted investment banking firms, and what those firms will expect from your business in exchange for their investment.
Private equity vs. venture capital: The key differences
Private equity firms and venture capital firms both invest in businesses in exchange for ownership interest. The key differences between the two lie in the types of businesses in which the firms invest.
Private equity (PE) investments
Private equity investors seek out businesses with a proven track record of revenue generation and require a detailed business history before agreeing to make an investment. These firms aren’t in the business of investing in risky startups that may or may not create the next great product or service.
Instead, PE firms aim for a positive return on their investment through tweaking well-established business practices. In a Harvard Business Review article, professors Paul Gompers, Steve Kaplan, and Vladimir Mukharlyamov summarize these tactics in three categories of business engineering:
Financial engineering: Incentivizing executives to focus their efforts on profitability. This could include anything from debt reduction to margin improvement.
Governance engineering: Encouraging a board of directors to actively engage the business in a manner that forces management changes to the benefit of the private equity owners. This could include the board changing compensation packages, acquiring new private companies, or reorganizing business units.
Operational engineering: Introducing changes to the business operations that streamlines supply changes, reduces waste, and increases efficiencies, along with other practices that lead to greater profitability.
The professors describe all three methods as “value-increasing” techniques that private equity firms deploy to increase the profitability of the target company. As the names suggest, these methods don’t focus on new product development or business model disruption. Instead, they focus on financial management, reorganization, and operational efficiencies.
PE firms look for sound businesses that could benefit from structural changes. To demand and enforce these structural changes, private equity firms need control of the target business, which is another hallmark of private equity investing.
PE firms generally invest in exchange for 100% ownership of the company, or at least a substantial majority share. Control over the target company allows the private equity firm to implement the business-engineering practices needed to achieve their goals.
While structural changes can improve profitability, those improvements are somewhat limited. Private equity firms understand this, and this accounts for a third aspect of private equity investments: Private equity firms expect modest returns on their investments. Gompers, Kaplan, and Mukharlyamov report that most private equity firms target a 20-25% return on investment.
Private equity firms invest in businesses that
Have an established record of business;
Are willing to sell 100%, or close to 100%, ownership interest;
Can benefit from business engineering techniques; and
Return 20-25% on investment.
Venture capital (VC) investments
Venture capital firms invest in markets for early-stage businesses. Typically, these businesses are quickly growing their customer bases. They may have started generating revenue, but venture capitalists will invest in pre-revenue businesses if the customer base is growing rapidly.
Venture capitalists aren’t dissuaded from investing in companies that have no history of profitability. Consider Instagram. Instagram had not yet generated a dime of revenue when Facebook acquired it in 2012. Despite Instagram’s lack of revenue generation, highly esteemed venture capitalists (Baseline Ventures, Andreessen Horowitz, Benchmark Capital, Jack Dorsey, Chris Sacca, Joshua Kushner, and more) had invested heavily in Instagram.
What were these venture capitalists hoping for in return for their investment in a pre-revenue, free photo-sharing app?
They were hoping for a massive return on what some would see as a risky investment. An ROI of 20-25% wouldn’t have interested any of these venture capitalists. Instead, they were looking for an exponential return, which they received when Facebook acquired Instagram for $1 billion.
Venture capitalists Peter Thiel and Reid Hoffman discussed this venture capitalist requirement in an episode of Masters of Scale. Thiel and Hoffman, both PayPal co-founders, recalled their early days at the online payments company, saying there was no revenue at the time.
But revenue wasn’t the focus. Instead, “exponentially growing users, and exponentially growing costs” ruled the day.
It’s that mentality that attracted venture capitalist investment. While increasing customers and costs without revenue might not seem like an economically sound strategy, the risk is worth it if the payoff is big enough. Eventually, PayPal sold to eBay for $1.5 billion, and PayPal’s user growth-over-revenue strategy was never questioned in hindsight.
Venture capitalists make risky investments in unproven startup companies. So how do they manage that risk?
Instead of looking for 100% ownership, as private equity firms do, vc firms use equity and make smaller investments in a large number of businesses. In return, they take a smaller amount of equity in the company — 10%, for example.
Venture capitalists fully anticipate losing most of their bets. However, the exponential wins, like Instagram and PayPal, more than make up for the many losses along the way.
VC firms invest in startups that
Have a disruptive product or service;
Are quickly growing their user bases;
Are looking for minority-share investors with a good network of contacts;
Need capital infusions to continue innovating and fueling user growth; and
Could offer an exponential return on investment if successful.
PE firms and VC firms seek out vastly different investment opportunities. So, what will these two types of investors expect from your business?
What are private equity firms looking for from founders and CFOs?
Since private equity firms are in markets with established businesses and have opportunities to tweak financial and operational practices, they expect a detailed history of financials and a proven record of revenue generation.
The more financial information you or your CFO can provide, the better your chances of landing private equity investment. Within the financial minutiae lies opportunities for a private equity firm to analyze those details and cut costs or improve margins. From the perspective of a private equity firm, more data results in more potential to improve existing business practices.
Further, private equity firms look for large investments, often hundreds of millions to billions of dollars. When you hear of a publicly traded company “going private,” there’s likely a private equity firm involved. For example, Michael Dell made headlines in the tech community and the finance world when he took Dell private in 2013.
While most of the headlines presented Michael Dell as the acquirer, a large private equity firm (Silver Lake) was the driving force behind the complicated transaction. Silver Lake used its financial strength to acquire the company for over $24 billion and force major structural changes to the tech giant. In the coming years, Silver Lake would restructure the business operationally, make strategic acquisitions, and eventually take the company public once again, after the company had reached its target profitability.
Dell was a perfect target for private equity. It required billions to acquire, and there were many opportunities to restructure finances and business operations to cut costs and improve profitability.
What are venture capitalists looking for from founders and CFOs?
VC firms look to invest in companies that are rapidly increasing their customer base. Thiel uses the term escape velocity to describe the rapid customer adoption that venture capitalists seek. By growing a user base month over month at an ever-increasing speed, Thiel and Hoffman suggest that groundbreaking companies can not only stay ahead of the competition but also break free of competition altogether.
Venture capitalists believe that the founders who will reach escape velocity have a clear focus on the product or service that will eliminate the competition. Venture capitalists don’t want to see startup companies diversifying their products or services. Brett Berson, a partner from venture capital firm First Round Capital, explained:
“Most breakout startups have a solid core business. If you’re pitching nine potential revenue streams in addition to your core business, that is concerning. It implies you may not think the core business is that strong.”
Many qualities that venture capitalists look for are difficult to quantify. However, this doesn’t mean you can pitch a new product and blindly state it will change the world and result in an exponential return on investment. You must understand your market and the overall potential for your product or service.
Venture capitalists use the metric total addressable market (TAM) to quantify the potential upside if a product or service succeeds. TAM equals the entire market demand for your product. So if every customer in your business’s market segment adopts your product, the number of customers is the TAM.
While it might seem unfeasible that every potential user in the market would choose your product over the competition, Thiel’s escape velocity metric suggests this is exactly what venture capitalists are looking for in their investments.
No matter how you fundraise, DocSend can help
Raising money for your business is an exciting and challenging experience. While some guidelines exist to point you in the right direction, your fundraising rounds will always be unique to your business and the investors you pitch.
Using DocSend to store, share, and track your pitch decks allows you to seamlessly control access to your deck, tailor your messaging to the intended audience, and control distribution to whomever you want to receive your pitch.