When evaluating the two primary investment vehicles, the terms “venture capital” and “private equity” come up frequently. For example, VC firms tend to invest in start-ups because they prefer predictability and less risk. In addition, venture capital firms tend to return more cash than private equity firms do. Which is better? Read on to discover whether venture capital is right for your company. There are many benefits to both types of funds.
VC firms prefer predictability
There are some differences between private equity and venture capital firms. A private equity firm may be more apt to invest in a company that has a proven track record and has a strong market presence. A VC firm, on the other hand, may be more apt to invest in companies that have shown some promise but are still in the early stages of growth. Whether a VC firm is right for a company is largely dependent on the type of due diligence it performs.
For instance, VC firms often prefer to invest in niche business models, especially tech startups, while PEs generally prefer stable, well-established markets. However, the biggest difference between private equity firms and VC firms lies in their risk tolerance. VC firms believe that the only way to make money is to take risks, whereas PEs tend to prefer more predictable investments in mature industries. So, how can private equity firms compare to VCs?
VC firms prefer lower risk
VC firms usually invest in small, low-risk companies. These investors are extremely selective in the types of businesses they invest in. They see thousands of entrepreneurs in any given year, but only make a handful of investments. Those who make successful investments are those with a long track record. They’re also the ones who’ll stick around for years to come. This makes them the best choice for those seeking to invest in private equity.
While VC firms tend to invest in the most promising and risky companies within the first four years of a 10-year fund, private equity firms like to hold onto lemons. Often, these companies are underwater, so PE owners prefer to hold on to them than cut losses too early. Some PE firms have made money by merging two related companies. This creates a lucrative exit for PE investors, and in some cases, the merged company may have the opportunity to become a public company.
VC firms return more cash
One way to get VC firms to return more cash is to show them that you can create a company from nothing. They are looking for startups that are going from 0 to 1 and they need all the resources they can get their hands on to make that happen. A successful startup is one that can demonstrate success quickly, which helps them justify the time and money they invested in it. It also allows them to mark up their investment and attract new investments at higher valuations.
VCs typically compute an IRR and CoC range by taking into account different levels of operating success and exit multiples. One common metric for estimating operating performance is EBITDA. The VC will assume the best-case scenario, and then multiply projected EBITDA by other percentages. They will also consider a discount rate to account for the illiquidity of the company. The higher these percentages, the more likely it is that the VC will return more cash to its investors.
VC firms invest in start-ups
VC firms invest in start-ups for a variety of reasons. Many investors enjoy the excitement of a new company that is a disruptor in an industry. Typically, early- stage start-ups provide innovative products or services that change the way people live. Some of these companies may receive a hundred-to-one return on investment (ROI).
VC firms work to make sure that their investment is well-matched with the company’s needs. They spend time evaluating entrepreneurs and start-ups, and package and market deals to limited partners. They also provide guidance to entrepreneurs and stay in contact with investment bankers to analyze exit opportunities. These firms also invest in start-ups that use seed capital for research and development. The majority of the time, angel investors are involved in the early stages.
VC firms provide access to more than just money
VC firms provide startups with more than just money. Many of them offer access to expansion financing, known as mezzanine financing, and IPOs. In addition to providing money to start-ups, these firms can exit their investments through an IPO, acquisition, or secondary sale. Early-stage VCs often exit in later rounds, when new investors purchase their shares, or when the company goes public and new investors profit from the IPO.
When working with VC firms, entrepreneurs should understand their relationships with the various staff members and partners. Not all people will have the same title and may have different responsibilities. Understanding who will be involved in your business’s fundraising process can help you determine the proper level of involvement from your VC firm. While some people are empowered to write checks unilaterally, others may need the consent of senior partners. Some staff members may focus on analysis, operations, or sourcing deals.