What is the difference between Private Equity and Venture Capital?

Definitions and context

Private Equity refers to investments in unlisted companies. This investment allows the company to grow, develop, recruit, expand internationally, or launch new products or projects. In exchange for this investment, the private equity fund becomes a shareholder in the company.

For a deeper understanding of how private equity works and its purpose, read the article “What is Private Equity?”

Venture Capital (VC), on the other hand, is a subcategory of Private Equity that focuses on startups. These are young companies that are experiencing rapid growth but are not yet profitable. See the diagram below:

Therefore, Venture Capital is a Private Equity segment. When we distinguish between Private Equity and Venture Capital, we are making a commonly accepted linguistic mistake. In reality, the distinction is made between the more mature branches of Private Equity (such as development capital and transmission capital) and Venture Capital.

Both Private Equity and Venture Capital share the following characteristics:

• Investment in companies over a medium-term period (4 to 8 years)
• Supporting the company’s growth during this period
• Aiming to resell the shares at the end of the period for a capital gain.

So, what sets Venture Capital apart from other segments of Private Equity and why is it often contrasted with Private Equity?

 

Venture Capital remains a distinct segment of Private Equity

Different target profile for Private Equity and Venture Capital

As previously mentioned, Venture Capital primarily focuses on high-growth companies. These companies have yet to reach maturity and typically do not have a positive EBITDA.

As a result, the analysis of these targets and the method of valuing companies are distinct from one another. One cannot analyze an unprofitable but high-growth startup in the same way as a mature company that has established itself in the market for years.

Different investment goals

The investment philosophy differs between Venture Capital and Private Equity. Venture Capitalists acknowledge that many of their investments may not succeed, but they focus on companies that have the potential for significant growth. They are willing to invest even if the promised growth may not always be achieved.

On the other hand, Private Equity funds often prefer mature companies with steady but low growth and strong fundamentals. Development capital and buyout funds typically target profitable companies with identifiable opportunities for improvement such as the need to replace managers or invest in capital expenditures.

In this sense, private equity could be compared to real estate investment:

 

Targeted sectors in Private Equity and Venture Capital

Private Equity funds invest in a wide range of industries, while VC funds tend to concentrate on high-growth, promising companies in specific markets, such as technology, digital and innovative sectors (e.g. robotics, deep tech, SaaS, etc.).

 

Distinct investment approaches

Venture Capital is a higher-risk investment. When investing in young, high-growth companies, the risk is naturally greater compared to investing in a well-established, family-owned company with a 100-year history and steady EBITDA growth of 3% per year. Not all Private Equity targets have such characteristics, but generally, their history and financial stability offer more security.

Venture Capital funds hold a minority stake in the company. Typically, they invest in a company at its early stages. As an investor, diluting the management team too much is not desired, it’s important that they retain majority control to stay incentivized and motivated.

Note: It’s a common misconception that VC funds hold minority shares while private equity funds hold majority shares. This is incorrect. There are many growth capital and buyout funds that hold minority positions. By the way, this is frequently the case in small cap Private Equity.

Due Diligence and target analysis

VC funds devote significant time evaluating the market, the management team, and the company’s future growth potential. Their targets are young, fast-growing, and unprofitable, meaning they have limited history. This track record may not accurately reflect future performance due to strong growth. Besides, the lack of positive EBITDA makes valuation exercises challenging and uncertain.

However, this is not a significant issue in Venture Capital. The primary goal of a VC is not to buy at the best price, but to bet on the “right horse”. If the target company’s business plan succeeds, the exit multiple is so high that the entry valuation (+/- 20%) is relatively insignificant.

In Growth Capital and Buyout Capital, the approach is different. The expected growth rates are lower. In Private Equity, at least two business plan scenarios are often performed:

1. A “management” scenario with relatively attractive growth and profitability projections (still much lower than VC figures)
2. A more conservative scenario with limited growth projections, often just indexed to inflation.

In Growth Capital and Buyout Capital, it is crucial to ensure that both scenarios reach a minimum profitability threshold. To achieve this in the conservative scenario, the company must:

1. Repay its debt, as leverage becomes a growth lever
2. Ensure consistent purchase and exit prices. Buying the target at a bad price is not feasible, which is why entry valuations in Private Equity are higher compared to Venture Capital.

 

VCs will focus more on the following aspects when conducting their analysis:

• The team: They will examine the experience of the managers, their background, the strength of their network, and the complementary profiles of the founders. Although PE also pays attention to this, they may have more flexibility and can more easily consider replacing certain key managers.
• The management’s ability to execute the company’s plan.
• The size of the target market and its potential.
• The significance of the solution to a problem.
• The achievement of “product market fit,” meaning the match between the product or service and its market.
• The company’s growth strategy.
• The scalability of the offering or service.
• The availability of technology, patents, assets, operational teams, and resources necessary to reach the goals.
• The company’s ability to master a know-how that distinguishes it from its competitors and creates a strong barrier to entry
• After the first development phase (and after the seed stage), VCs will be more attentive to a set of KPIs related to the business. These indicators remain different from those encountered in development capital:
  • LTM (Life Time Value): Average revenue generated per customer over the life of the commercial relationship with that customer. LTM is generally compared to CAC
  • CAC (Customer Acquisition Cost): all the costs of acquiring a customer divided by the number of customers acquired
  • Thus, VCs will be interested in the LTV / CAC ratio and make sure that it is sufficiently important.
  • MRR or ARR for Monthly Recurring Revenue or Annual Recurring Revenue. This KPI is used for SaaS and other activities based on subscription sales. MRR is the monthly revenue generated by active subscriptions.
  • The Churn rate reflects the company’s retention strategy. It is calculated by taking the number of customers lost over a given period divided by the total number of customers.

Here are a few additional tips that could help you prepare for your venture capital interview

In addition to the (i) HR questions and the accounting, valuation, financial modeling or structuring topics, you may be asked about:

• (ii) Your knowledge of tech and the fund’s focus market areas
• (iii) Your understanding of the VC industry trends

All the elements of (i) are available in our Private Equity and Venture Capital training. You will also find additional resources and thematic reports on VC, tech, PE and M&A to help you prepare for the next (ii) and (iii) topics.