Doug Linman PhD is an engineering and technology expert with over thirty six years of experience. He is also the Chief Science Officer of the SUNTCO corporation, a firm dedicated to deploying solar liquid power through paint and coatings.

What is the difference between Venture Capital and Private Equity?

The text book answer that would be given by most B-School professors is that venture capital is a subset of a larger private equity asset class which includes venture capital, LBO’s, MBO’s, MBI’s, bridge and mezzanine investments. Historically venture capital investors have provided high risk equity capital to start-up and early stage companies whereas private equity firms have provided secondary traunches of equity and mezzanine investments to companies that are more mature in their corporate lifecycle. Again, traditionally speaking, venture capital firms have higher hurdle rate expectations, will be more mercenary with their valuations and will be more onerous in their constraints on management than will private equity firms.

While the above descriptions are technically correct and have largely held true to form from a historical perspective, the lines between venture capital and private equity investments have been blurred by increased competition in the capital markets over the last 18 – 24 months. With the robust, if not frothy state of the capital markets today there is far too much capital chasing too few quality deals. The increased pressure on the part of money managers, investment advisors, fund managers and capital providers to place funds is at an all time high. This excess money supply has created more competition between investors, driving valuations up for entrepreneurs and yields down for investors.

This increased competition among investors has forced both venture capital and private equity firms to expand their respective horizons in order to continue to capture new opportunities. Over the last 12 months I have seen an increase in private equity firms willing to consider earlier stage companies and venture capital firms lowering yield requirements to be more competitive in securing later stage opportunities.

The moral of this story is that if you are an entrepreneur seeking investment capital your timing is good. While the traditional rules of thumb first explained above can be used as a basic guideline for determining investor suitability, don’t let traditional guidelines keep you from exploring all types of capital providers. While some of the ground rules may be changing your capital formation goals should remain the same: entertain proposals from venture capital investors, private equity firms, hedge funds, and angel investors while attempting to work throughout the entire capital structure to seek the highest possible valuation at the lowest blended cost of capital while maintaining the most control possible.

An angel investor is one who does not desire much say in the management of the company in which he invests, and also favors a slower return on investment. However, it should be borne in mind that they still make investments in the hopes of making a profit. Angel investor groups are important means of private capital and often put in angel money into fresh companies.

Venture capitalists and angel investors are aiming for capital augmentation and revenue escalation, and proof that one’s business can bring sustained expansion over time, to offer a profit on investment.

The present venture capital market is still recovering from the burst of the “dot com bubble.” Venture capital continues to be a feasible means of funding startup companies. Entrepreneurs who have an appealing business concept should not be disheartened from seeking investment funds.

An angel investor is one who is eager to invest in a company in its nascent. While looking to finance a business idea, angel investors can be an ideal source for obtaining valuable funds.

An angel investor is not a worker or member of a bank, venture capital firm or other financial institution that generally puts together such investments.

Angel capital plugs the breach in start-up funding between the “three F” (friends, family and fools) and venture capital. Most venture capital funds will not take into account investments under $1 million, while it is hard to get in excess of $100,000 – $200,000 from friends and family. Thus, angel investment is a widespread investment option for high-growth start-ups.

While the terms and conditions of venture capital are not standardized, there are some salient features of venture capital arrangements. The venture capital firm is inclined to assume a high degree of risk in the expectation of earning a high rate of return. The venture capital firm, in addition to providing funds, takes an active interest in guiding the assisted firm. The financial burden for the assisted firm tends to be negligible in the first few years. The venture capital firm normally plans to liquidate its investment in the assisted firm after 3 to 5 years. Typically, the promoter of the assisted firm is given the first option to acquire the equity investment held by the venture capital firm.

Venture capital firms can raise funds from different sources. The important long-term sources of finance are issue of equity shares and preference shares, issue of debentures of different types, raising of term loans from financial institutions and generation of reserves. Venture capital firms may use different combinations of these sources by considering their relative cost and availability and their impact on the value of the firm. Accordingly, a company can have patterns of capital structure such as equity shares only, equity shares and preference shares, equity shares and debentures, equity shares and preference shares reserves, equity shares and preference shares debentures, equity shares and preference shares/debentures reserves.

The capital structure of venture capital firms is influenced by number of factors such as trading on equity, growth and stability of sales. Trading on equity means the use of long-term, fixed interest bearing sources of finance along with equity capital. Adopting trading on equity can increase the return on equity. However, this is possible only when the return on investment is more than the cost of finance.

Private equity is a kind of equity investment in an asset that cannot be traded freely on the stock market. Private equity is of many kinds, including mezzanine capital, angel investing, leveraged buyout, venture capital etc.

Private Equity: How it Works

Private equity funds are set up as limited partnerships. These limited partnerships are controlled by private equity companies that are the general partner in the limited partnership. The private equity company encourages individuals and institutions to invest in the private equity fund. This way, the investors become limited partners, though the general partner controls the company management. When the general partner thinks that a particular investment is feasible, it asks the limited partner to invest the amount it guaranteed. The general partner chooses the investment portfolio of the partnership, while the limited partner provides funds for investing. The limited partner, or investor, in turn profits through sales, mergers, recapitalization or initial public offering.

Categories of Private Equity:

Private equity has many kinds of investments that fall under it, but the major ones include growth capital, angel investing, venture capital and leveraged buyout.

Advantages of Private Equity Funds:

1) Funds gotten through private equity are crucial for the growth of industry and the development of innovative products.

2) Private equity funds are used for expanding working capital.

3) Private equity funds are helpful when it comes to facilitating mergers and acquisitions.

4) Private equity funds make a company’s balance sheet stronger, and help it develop.

5) Private equity funds are a great way to obtain funds for small businesses and start-ups that have not been able to get loans or grants.

6) The general partner runs the company, so the investing partner, or the limited partner, cannot interfere in the management of the company.

Disadvantages of Private Equity Funds:

Apart from advantages, private equity funds have certain drawbacks.

1) Since private equity funds are not open to investment on the stock market, anybody who wants to sell stocks of a private equity fund finds it difficult to locate a buyer.

2) There are certain transfer limits on private equity.

3) Most individuals cannot afford the high investments required in a private equity.

Private equity funds are an excellent investment options for venture capitals and other organizations looking for long-term investment in projects that will bring in good returns. However, they are not open for public trading and not affordable to minor investors and individuals. Forming a private equity fund is a good option for small business owners who have not been able to source funds for their start-ups or long running business from any other source.