Originally published February 21, 2012
Venture Capital and Private Equity get a lot of media attention. Sometimes they are the "genius" talent scouts of the business world, investing into companies with astounding foresight. In other narratives, they are the ruthless capitalists, taking control of companies and ejecting management teams from the driver's seat like carjackers. As it turns out, neither of these stories are very accurate.
Venture Capital and Private Equity firms are key components of the corporate finance landscape, offering growth capital and liquidity at critical moments in the evolution of companies when more traditional sources of cash, like banks or public markets, are unavailable or unwilling to invest. But like all professional investors, these firms have a job to perform on behalf of their limited partners. These firms survive their own torturous sales and diligence processes to convince pension funds, banks, universities, hedge funds, fund-to-funds, and other institutional investors that they will successfully earn returns superior to public indexes and other asset classes. This is no job for the faint of heart.
Interestingly, the differences between venture capitalists and private equity firms are often misunderstood, in part because some firms have both types of investment funds housed under the same umbrella. Publicly they are often treated as the same kinds of investors, where the only difference is the average deal size. The story goes that venture capital will put in a few million, but private equity will put in tens or hundreds of millions into companies. While average deal size is a critical differentiator between the two types of capital because of the implications for the fund structure and business model, it is by no means the only difference. I have worked on private equity deals as low as $4,000,000 and venture capital deals for greater than $50,000,000.
But the real issues are that, for the most part, they do not invest in the same kinds of companies. Primarily they differ when it comes to the stage of companies in which they invest, as well as the breadth of industries they will consider. In addition, they have differing requirements on total market size, likely return range, return horizon, technology risk appetite, market adoption risk, competitive environment, liquidity for founders, size of investor stake and whether a prospective portfolio needs a new disruptive technology or only potential for sustainable future cash flows.
Companies seeking capital from venture capital and private equity are well advised to first understand the priorities and goals of these firms, and to understand which might be a fit for their current needs. Once understood, crafting an investment deal that aligns the interests of all parties is not only possible, but usually provides benefits far superior than investments from banks, public markets or other sources of silent cash. Why? Because the premise of both kinds of firms is that outsized returns are the result of the human capital deployed by the firms into the investment. It is the venture capitalist and private equity teams that help move companies forward. As such, the very first job of any company seeking capital is to form relationships and to judge the quality of the humans involved. While firm level reputations are good general guides, they are absolutely no substitute for working with individual partners and teams at the investment firms to gauge whether these are the kind of investment and operational partners you want for years to come.
Equally, many growth or expansion stage companies often believe that obtaining fresh capital will solve all of their problems. While more cash can usually (but not always) accelerate operational goals, the wrong type or timing of new capital is often not in the best interests of current equity holders. A financing plan that articulates and balances the need and uses of cash with the resulting dilution and preferential treatment of the new money is critical. But that is the beginning of the analysis not the end. Companies and investors need to align on issues of control, leverage, management, culture, values and their operating relationship. Only after this courtship results in (mostly) true love will there be a venture capital or private equity deal that is right for you.
This update is for information purposes only and should not be construed as legal advice on any specific facts or circumstances. Under the rules of the Supreme Judicial Court of Massachusetts, this material may be considered as advertising.