At first glance, private equity and venture capital look more or less the same: firms with lots of money investing in privately-held businesses and hoping to land big returns. But there are key differences between the two, namely in the kind of companies they invest in.
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Here at Crunchbase News, we write primarily about venture capital. But every so often, our articles include mentions about private equity firms (e.g. TPG, Vista Equity Partners) and hedge funds (Tiger Global Management has been investing a lot in tech) when they invest in startups.
So while the two are set up similarly and aim for similar outcomes, the way they operate is different. Let’s take a look.
Venture Capital: Move Fast, Break Things, And Make A Lot Of Money Doing So
Venture capital is money that often helps get a business off the ground. A VC firm invests early in a company’s life and gives it the critical capital it needs to start and, with luck and hard work, grow. VC firms place a premium on growth, often at the expense of profitability, so they’re more inclined to invest in companies with high growth potential, and direct companies to grow quickly, if not always sustainably. Venture capitalists are playing the long game, investing early in companies that could one day could deliver huge returns.
VC firms are often associated with technology startups (probably because so many tech startups are backed by venture capital) but VC dollars go to other kinds of ventures, too: Blue Bottle Coffee and WeWork are two examples of startups that attracted venture capital, even though they aren’t tech companies (no matter how much WeWork tries to brand itself as one).
The money in a VC firm’s fund comes from its limited partners, which, depending on the size and setup of the fund, can include high net worth individuals, their family offices, and institutional investors like charitable or university endowments, pension funds, fund-of-funds, and other money management firms. General partners—the folks managing the firm—traditionally make an investment in their funds as well, to ensure they have “skin in the game,” aligning interests between GPs and LPs. VC firms tend to make “riskier” investments that are spread out over several companies. That way, if one or multiple startups fail (which they probably will), the whole fund doesn’t sink. And if just one or two companies from a particular VC fund are a huge success, that’s excellent for the firm.
Because the venture capital market has grown more crowded, VCs often compete with one another for allocation in funding rounds. Many investors try to differentiate themselves by offering a suite of services, often tailored to a specific subset of companies, which they use to justify taking significant stakes in their portfolio companies. VCs may also take seats on a company’s board of directors. In theory, this should grant them additional governance and control rights over their portfolio companies, but the rise of multi-tier voting share structures (typically favoring founders) and a recent tendency to defer to founder authority can mean that directors have less power than they once did.
Private Equity: Steady As They Go
Private equity firms, on the other hand, focus on more established businesses that need a capital boost and reorganization so that they can be sold at a profit. They’re something like house flippers.
Asset management company BlackRock laid out how private equity works in three steps: Buy, Change, Sell. A private equity firm will buy a stake in an established company (usually a much bigger stake than a VC firm would), restructure and revamp the business so that makes more money and then sell it at a profit (e.g. through an IPO).
Private equity is seen as less risky than venture capital, because private equity investors are investing in a company that’s already established some business fundamentals—not two founders with a laptop and a dream. Private equity firms will often take a larger stake in companies, according to Investopedia.
Ping Identity is a good example of a company that has a history with venture capital and private equity. Ping started off as a venture-backed company, raising its $5.8 million Series A from General Catalyst in 2004. It raised $128.3 million in venture capital funding from 2004 to 2014, with the amounts fluctuating each round.
The company was acquired by private equity firm Vista Equity Partners for $600 million in 2016. How Vista restructured Ping is unclear, but the company had a nice exit just a few weeks ago. Its IPO raised $187.5 million before trading started, and its stock popped 25 percent on its first day of trading. The company had a market cap of nearly $1.25 billion as of October 16.
However, the lines of private equity and venture capital are becoming increasingly blurred.
Postmates, for example, received a $225 million investment from private equity firm GPI Capital in September. The company was already well-established, having raised money from venture capital firms like Spark Capital and Founders Fund. Postmates also received hefty investments from BlackRock and hedge fund Tiger Global Management. But Postmates also pulled in a ton of venture capital, and is commonly referred to as a VC-backed startup.
How much more the two will overlap in the companies they choose to invest in is unclear. But both are evolving as private companies chasing profitability evolve.
Jason D. Rowley contributed to this article.
Illustration: Dom Guzman