Private Equity vs. Venture Capital: What’s the Difference?

What is private equity?

Private equity (PE) is an alternative investment where a private equity fund or investors directly invest in privately held companies. Institutional and retail investors provide the capital the business uses to buy new equipment or technology, pursue bolt-on acquisitions, chase growth opportunities or improve business cash flow.

What are examples of private equities?

Private equity funds can come from various sources. However, equity firms are the most common sources, including the following:

• Insurance companies
• Investment funds
• Credit unions
• Trusts
• Pension funds
• Investment banks

Major companies have often been purchased through private equities, and it’s a common occurrence on the show Shark Tank. It’s essential to distinguish between PE investments and publicly traded investments. Publicly traded companies can be purchased. However, it does not qualify as a PE unless it becomes private at the end of the deal.

What are common PE strategies?

A private equity fund is motivated to make investments in private companies for several reasons:

1. A private equity fund may buy out a company: A common practice among private equity companies is buying a business outright to improve it and then selling the business for a profit. This is known as a leveraged buyout. Alternatively, the PE firm can launch an initial public offering, which is when a private company sells shares to the public.
2. A private equity fund may provide distressed funding: If a business is struggling, PE investors will provide distressed funding to turn around its operations or sell off its assets for a profit. Typically, a private equity firm gets a majority stake in the business seeking the funding.
3. A private equity fund may cash out founders or other investors: PE investors may want a business but not the people running it. In this case, they’d use PE funding to buy out the founders or existing investors. Private equity can also be used to expand the business or recapitalize if the enterprise is struggling.

Private equity investors tend to focus on mature, stable companies that have already exited the growth stage of the business cycle.

“Some of them focus on small companies, but it’s not typical,” explained Zsuzsanna Fluck, director of the Center for Venture Capital, Private Equity and Entrepreneurial Finance at Michigan State University. “They typically invest in companies with $100 million to $500 million or more and some middle-market companies that are below $100 million.”

What are the pros and cons of PE?

Like any funding type, private equity has pros and cons. 

On the positive side, PE investors bring more than cash to the table ― they offer expertise and experience. “PE investors usually have some expertise in the industry and may want to help acquire other companies and get bigger,” said Steven Neil Kaplan, professor of entrepreneurship and finance at the University of Chicago’s Booth School of Business. “You may not be running it as well as you can and they bring in the real expertise.”

PE negatives include the following: 

• Business owners must give up control: The biggest disadvantage of PE investments is that business owners must give up control. PE investors typically get a majority stake in the operations, which means they have free rein to get rid of executives (including the owner), implement changes and sell the business. If the PE investors want to lay off employees to boost profits, you won’t be able to do much about it.
• PE investors could sell the business: Another potential disadvantage is that the business could be sold. PE investors are in it to make money. They want to improve the business, sell it for a profit and move on to the next investment.

What is venture capital?

Venture capital investing is when a group of investors or funds injects cash into a business in exchange for minority stakes. Like private equity investors, venture capitalists invest in private companies.

What are examples of VCs?

Here are two examples to help you better understand venture capitalism:

• Google’s GV division: Google is perhaps the most prolific venture capitalist in the world. The company has a division known as Google Ventures (GV), which has the sole purpose of investing in promising companies. GV is why you hear about some of the more interesting or random Google projects like fiber internet, wearable technology and self-driving cars.
• Shark Tank: On Shark Tank, investors frequently make venture capital investments. They don’t want to control the company. Instead, they provide cash to jump-start the business while accepting a noncontrolling equity stake as compensation for their investment.

What are the types of venture capital?

Venture capitalists and venture capital funds invest in startup companies at different stages of the business life cycle. The three primary venture capital types are seed capital, early-stage capital and late-stage capital.

1. Seed capital: Entrepreneurs seek seed capital funding when starting a business. They likely don’t have a product or a company structure yet. Investments tend to be small at this stage. Funding is often used to develop a product, cover startup costs or create a market research plan.
2. Early-stage capital: Early-stage capital funding is geared toward companies that have been running for a few years and have a growth mindset. The business has a structure, management is in place and revenue is rising. Funding is typically used to boost sales, reduce business expenses and enhance operations.
3. Late-stage capital: Late-stage capital funding focuses on companies experiencing fast growth and looking for funds to get even bigger. Companies raising this type of funding have already disrupted the marketplace.

“Venture capital is for businesses in the earlier stage that can really scale,” Kaplan explained. “They have some revenue, but they need a lot of money to grow.”

Venture capitalists are known for investing in technology companies, but they also make bets on businesses in other industries ― if the business has the potential to be huge. 

What are the pros and cons of VC investments?

Like other funding types, VC investments have pros and cons. 

Upsides to VC capital include the following: 

• VC investments can take your business to the next level: Venture capital can be extremely helpful for taking your business to the next level. A venture capital investor often serves as a mentor, guiding your startup as it expands. 
• VC investors streamline networking: Venture capitalists tend to have many contacts, helping you network with the right players.
• You don’t have to repay VC funding: There’s no obligation to pay any of the money back ― a significant upside to VC investments. 

However, there’s a significant downside to VC capital. Raising VC capital is challenging ― and it’s only gotten more complicated since the COVID-19 pandemic. “[VCs] are really looking for the needle in the haystack,” Kaplan noted. “They fund very few companies.” If your business isn’t disrupting a market and can’t get to the $50 million in revenue mark in five years, VCs may not be interested.

What are the main differences between PE and VC funding?

Private equity and venture capital target businesses at different stages, with owners giving up varying degrees of control. 

“Venture capitalists focus on high-growth companies that have the potential to disrupt the industry and are growing at a high rate,” Fluck explained. “Private equity is more about middle-market companies that are relatively stable and more mature.”

Consider the following differences between private equity and venture capital funding:

1. PE and VC investors want different degrees of control: Private equity is for business owners willing to give up majority control of their operations. VC investors are only interested in a minority stake.
2. PE firms are more available and broader: There are more private equity firms than venture capitalists, so it’s easier to find and attract investors specializing in PE. A PE firm casts a broader net, investing in various industries. A VC firm is only interested in startups that have the potential to disrupt a market.
3. PE and VC investors have different timetables: Both PE and VC investors bring knowledge and expertise to the equation. However, PEs seek a quicker turnaround on their investment than a venture capitalist, who is willing to wait for the payout.
4. PE and VC investors focus on different sales levels: Private equity firms won’t touch a company without sales, but a VC firm will. VC investing tends to be risky because the company is just starting out.
5. PE and VC investors focus on different business models: While both invest in a wide range of companies and industries, VC firms are far more interested in niche business models. VCs are particularly interested in tech startups. PEs like predictability and tend to favor businesses in established markets.
6. PE and VC investors tolerate different risk levels: Perhaps the biggest difference between PEs and VCs is risk tolerance. Venture capitalism is built on the idea of taking risks to make money. PEs are very risk-averse and will only invest in companies that have established proof of their ability to make money.
7. PE and VC investors look at different business sizes: Business size distinguishes VCs and PEs. PEs favor businesses that have already shown a reliable growth model. VCs often invest in businesses that have yet to make any money. Because of these differences, venture capitalists more often invest in small businesses, while PEs will invest in medium or larger companies.
8. PE and VC investors differ in leadership demands: A private equity investment almost always comes with a change of leadership. This means that operations are also likely to be overhauled. Venture capitalist investments do not come with a change in control of the business. While VC investors might offer compelling advice, operational overhauls are rare.
9. PE and VC investors view emerging markets differently: Another significant difference is the concept of emerging markets. PEs rarely acknowledge emerging markets. Instead, they want more control over saturated markets. VCs are constantly searching to forge the next emerging market. It is a higher-risk, higher-reward strategy.

Despite these differences, a company seeking alternative investors should look for the same attributes from the private equity companies or venture capital firms they work with. That means partnering with someone who knows the business and genuinely wants to help.

“If you get money from somebody who doesn’t understand the business, that’s dumb money,” said Kaplan. “That is not going to help you.”

Jamie Johnson contributed to this article. Source interviews were conducted for a previous version of this article.