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Private Equity vs. Venture Capital: What Founders Need to Know

  • What the key differences are between venture capital and private equity
  • Why founders might be better served by one or the other

If you’re a bootstrapped or minimally funded founder, taking on outside investment from a venture capital or private equity firm has likely crossed your mind.

Without much experience, you may not know the difference between these two categories of investor. You may even lean towards VC just by virtue of the fact that VC tends to be more publicized and therefore more familiar to founders than private equity.

Private equity and venture capital have very different approaches to investing, and as a founder these approaches will affect your level of risk, your role post-transaction, and your ultimate outcome. Before you settle for one investor type or the other, make sure you understand what sets them apart.

Below are the key differences between private equity and venture capital and how they concern you as a founder.

Risk Profile

Venture capital and private equity funds differ in how willing they are to take on risk.

VC investors tend to build large, diversified portfolios of higher-risk, early stage investments. According to the venture capital investment thesis, so long as a few portfolio companies hit a home run, it doesn’t matter so much if the rest of their portfolio strikes out.

In order to create the ideal conditions for home runs, VCs will advise their portfolio companies to pursue risky strategies that lead to boom or bust situations. Not every founder is comfortable with that level of risk, but for founders who are willing to bet the farm on a large market opportunity, VC can be the right path.

Private equity investors, on the other hand, are more risk averse than in VC, though that’s not to say they aren’t willing to accept some risk with the promise of a high return.

Still, instead of betting on a couple investments to cover the losses of all others, PE funds expect each of their investments to generate a return. PE investors therefore employ more conservative strategies with their portfolio companies with the aim to generate good returns for each.

Unlike VCs who are willing to bet on an early stage company, PE firms tend to only invest in companies with a proven thesis. For a company that clears a PE’s required threshold of performance, private equity is a great path to realize a return from growth without excessive risk.

Application of capital

As a founder, an important aspect of taking on investment is the type of capital consideration you will receive upon transacting.

When VC funds invest, they tend to place all their investment onto the balance sheet of the company to fund future growth (known as an investment of "primary capital"). Because VCs are investing in early stage companies without a proven thesis, they prefer not to give liquidity to founders (known as “secondary capital”). They may in some cases pay out secondary capital, but usually not enough to significantly de-risk a founder’s personal finances.

Note that an investment of primary capital is dilutive, so for a founder’s economics to make sense, a VC investment has to contribute enough growth to offset dilution. If your projected growth is large enough to do so, VC can be a good path.

Private equity firms usually take a different approach in providing primary vs. secondary capital. While growth capital (which is primary) can certainly play a role in an investment, most often a private equity transaction will involve a minority or majority recapitalization in which the PE firm pays out secondary capital to the founder in exchange for equity. With a recapitalization, a founder can take some chips off the table while also rolling over some of their equity in the business for future upside.

Approach to growth

How quickly you grow is an important aspect of your company’s strategy, and VC and PE firms approach growth differently.

VC investors want their portfolio companies to grow quickly and therefore will often encourage them to operate cash-flow negative to do so. Applying this approach, a company can claim significant market share early on, which under the right circumstances can create a great outcome.

Something to note is that growing cash-flow negative can create a dependency on VC money—when the bank account runs low, a founder will have to raise another dilutive round of capital. So again, founders need to consider whether or not a series of capital infusions will produce enough growth to offset dilution.

Private equity investors focus more on moderate, operations-driven growth, which usually aligns better with how a bootstrapped founder has historically run their business.

Market size

Market size is important to all investor classes—the main difference between VC and PE is in the impact an investor’s strategy will have on a founder’s final outcome given the market size.

Considering how VC firms invest (i.e. with dilutive primary capital in multiple rounds), venture capital money better serves companies operating in very large markets where the pie can grow enough to offset dilution. If the market is too small, multiple dilutive fundraises just don’t make sense for a founder.

VCs do invest in smaller markets, but the home run is also smaller and founders receive less of the outcome. In addition, when operating in a smaller market, a VC is more likely to structure their equity as more onerous securities, many times in the form of participating preferred securities, which will significantly reduce a founder’s economic payout.

Considering how private equity firms invest (i.e. with non-dilutive secondary capital), companies operating in smaller markets are better off pursuing a minority/majority recap with a PE investor, then rolling over some of their equity for future upside. So long as your TAM is large enough for your company to reasonably grow revenue 3-5x within its market, you will likely be able to attract interest and realize a return from a private equity investor.

Choosing the Right Path for Your Company

If as a founder you’re comfortable with risk, your market is large enough, and you’re willing to bet that the pie will grow enough to offset dilution, then venture capital might be the right path for you. If, however, you are more concerned about protecting what you’ve built, while also taking some chips off the table and participating in future upside, then private equity might be a better path.

Modified on Sep 23, 2021