Private Equity and Venture Capital Financing – that will be the topic of today’s article.
Explore private equity and venture capital financing alongside insights from Custodian Life.
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Private Equity
So, what is private equity?
Assuming that you already know a thing or two about stocks, stocks represent partial ownership of companies.
Not just any company, but the company that is usually listed on a stock exchange. Even companies that aren’t listed on a stock exchange can offer stocks to an individual.
The term equity is associated with the value of shares in a company.
For example, if we say that David has 77% equity in a certain company, then David owns 77% of the company.
Now we know what equity means, private equity refers to the private ownership of a certain company.
People who invest in private equity are known as private equity investors, who invest with the help of a private equity firm.
Not everyone can be able to invest in private equity as it has a requirement for a higher amount of capital.
Let’s talk about who can actually invest in private equity investments.
Accredited Investors
An accredited investor is an individual who is allowed to invest in instruments that do not abide by the regulatory authorities.
Accredited investors usually have a significant amount of income and net worth and can be a person or a company.
Institutional Investors
The name itself gives away half of the definition for this term, i.e., institutions that want to invest.
Generally, many entities such as banks, insurance companies, retirement funds, pension funds, hedge funds, etc. come under the category of institutional investors.
In layman’s terms, institutional investors are institutions that want to generate returns by investing some of their profits or capital.
If you want to invest in private equity, you must either be an institutional investor or an accredited investor.
These investors can own all the equity or a fraction of it in a private company or a public company.
Unlike most other types of investments, private equity investments have a longer timeframe that ranges from 5 to 10 years.
Private equity firms, which offer investment opportunities related to private equities, look for higher returns.
As a rule of thumb, most private equity firms generally seek around 250% returns on the investments made.
Private Equity investments, as I said before, come with longer time horizons.
Adding to that the companies get all the funding needed to finance new technologies, make acquisitions, or acquire more working capital.
This allows them to go ahead and make profits for the investors who have provided the necessary funds for the company’s growth.
Private equity investors usually sell their equity via an initial public offering or when the company is acquired by a larger company.
If the private equity investment is made in a public company, then the company is delisted from the stock exchange.
The process of delisting a company from a stock exchange by private equity investors is known as taking a company private.
Why delist?
This is usually done for companies that are experiencing severe losses so that they have time for growth.
Such growth strategies may not be allowed by the stock market because those who invest in the stock market seek quick returns.
Therefore, a company will be delisted as private equity investors can wait for a longer time until the company sees growth.
In general, private equity funds invest in companies that have been existing for a while rather than start-ups.
The companies are managed by private equity firms so as to increase their value before exiting them later.
Private Equity Firms
Talking about private equity firms, these are the companies that buy private equity stakes from other companies.
These firms can keep the stakes for themselves or they can sell the private equity to institutional investors, hedge funds, and private investors.
These private equity firms can be private companies or they can be companies that are listed on a stock exchange.
Private equity investments mostly involve investors with a larger amount of capital. Such investors are usually looking for a deal that earns them huge profits.
It has been reported that the top 10 private equity firms are said to own half of the private equity assets globally.
Private Equity Funds
You all know that a mutual fund is a pooled investment where the fund manager invests the pooled money in other assets.
Similarly, a private equity fund is a pooled investment where the pooled money is used to make investments in private equity.
Private equity firms handle different funds, and at the same time, try to raise capital for a new fund every 3 to 5 years.
The firm tries to raise money for the fund as the money from the previous investors gets invested into an investment opportunity.
Firms get to boost the internal rate of returns (IRR) through the utilization of borrowed funds.
Because the interest rates are low, the firms borrow funds when they want to make a new investment.
When the investment has been held for a while, the firm uses the cash from the investors to pay off the loan.
Furthermore, the ownership of the asset is taken into the hands of the firms when it seems profitable.
Hence, investors feel as if they have received higher returns over a short period of time.
The IRR is also great, especially because of using borrowed funds.
Types
The deals regarding private equity can be categorized into the following types based on the situation.
The first type is where the acquisition of an entire company takes place, and the company can be public, closely held, or privately owned.
The investors who acquire an underperforming company try to cut costs and restructure the company’s operations.
Another category of private equity is where private equity investors buy a stake in a large business.
In most cases, such as business would be a subsidiary that has been put up for sale by the parent company.
Such a category would be known as a carve-out and these offer lower valuation multiples. However, the carve-outs are known to be riskier compared to other types of private equity acquisitions.
Next is the secondary buyout where the firm purchases the company from another private equity firm instead of buying a listed company.
Usually, these types of deals were often known as distress sales, yet they have become more common these days.
For example, a PE firm might buy a business to cut costs and sell it to another PE partnership so that it can acquire a complementary business.
Another exit strategy is where the private equity is sold to the competitor, which includes the portfolio company as well as the IPO.
Advantages and Disadvantages
Having covered all the necessary information, let us now have a look at the pros and cons of private equity investments.
Pros
Let us begin with the advantages.
Growth Potential
The main objective of private equity investments is to gain profits from the growth of the portfolio company.
As the companies get additional funds, they can get new resources, shape up their business structure, acquire other companies, and avoid bankruptcy.
This allows them to have all the means necessary to grow, and when that happens, investors are able to gain profits.
Guidance
PE investors, in most cases, just invest the money and opt for a hands-off approach.
But when the company is in the early stages of development, it might also get the guidance and advice necessary.
Such guidance and advice are not only advantageous for long-term growth, but they can also help struggling or failing businesses.
Flexibility
On par with the public sector, the private sector is known to offer many investment opportunities.
This means individuals can choose from different sizes of businesses and different sectors.
The flexibility also comes for the stages of business such as offering seed money, development, expansion, ready to go public, etc.
Returns
Apart from the growth of the company, with all the necessary funds obtained, the company can get more profits.
Resilience
Despite the volatility that took place over the past decade, the private equity market is known to be much more resilient.
This has been observed even during the times of COVID-19 when most of the public sectors took a hit.
Cons
Now, let us take a look at the drawbacks of private equity investments.
Accessibility
Unless you have a hefty sum of money available at hand, it is hard to get into the realm of private equity investments.
In general, you will be required to have at least $250,000 or more to become a private equity investor.
Risk
Even when there is a scope for huge growth, private equity investments come with a higher risk.
When the investment has been done in a company that is in its early stages, the investments are likely to be at risk.
No transparency
Private equity investments do not come with a transparent report on all the details necessary.
For a publicly listed company, all the information is transparent, particularly when it comes to financial information.
That’s not the case with portfolio companies of private equity investments.
Venture Capital Financing
Venture capital financing is similar to private equity investing, where the major difference is that the investment is made in start-ups.
Venture capital financing is a risky investment where the money is invested in a company that is not publicly traded.
This is planned for three major stages of a company that is being financed, i.e., the idea stage, expansion stage, and exit stage.
Usually, the investment is done in a company that is already in business and selling a certain product.
Such a product will have potential and the venture capital company recognizes and wants to improve the performance of the company.
When to exit from the company is prearranged and done through an IPO or a buyout.
Methods/Types
Now let us have a brief look at the different methods of venture capital financing for a better understanding.
Equity Financing
Imagine a startup company that requires additional capital and has a good business plan as well as a potential for growth.
Such a company would often seek equity financing. Here, a percentage of the business of the company is offered to investors in return for capital.
This is generally the case when the company is not able to offer returns to its investors on time.
The investors who have invested in a company through equity financing are offered voting rights.
In layman’s terms, equity financing refers to raising capital by selling a fraction of the company in exchange for capital.
With equity financing, investors get ownership rights as well as voting rights.
As ownership rights are offered, investors need to share their profits whenever the company announces a dividend.
Shareholders are offered a dividend from the profits that have been earned by the company.
Companies are subject to dividend distribution tax regardless of the dividend amount.
Conditional Loan
Conditional loans do not have any pre-determined repayment schedules or fixed interest rates for the funds borrowed.
With conditional loans, the startup company is required to pay the lender in the form of royalty from the revenue or the profits generated.
There is no necessity to pay interest to the lender when the startup goes for a conditional loan.
Usually, the royalties range from around 2% to 15% depending on the revenue, profits, and cash flow.
Conventional Loan
On par with conditional loans, companies that acquire a conventional loan are required to pay a low interest rate on the borrowed capital.
In addition to the interest that is to be paid initially, startup companies are also required to pay royalties.
The royalty that is to be paid depends on the sales or profits of the company.
Income Note
An income note is a combination of debt financing as well as a conditional loan. The companies that have opted for income note type of financing are required to pay:
— Principal amount along with the interest amount within a specific prearranged time period.
— Royalty on sales/profits.
Debentures
The start-up companies raise capital with a debenture while guaranteeing to repay the invested money upon maturity of the security.
To make it simple to understand, companies issue a debt paper for a specific period.
The company then pays the interest on the invested capital upon the maturity date. With debentures, the interest is paid at three different rates with respect to the phase of the business.
The stages at which the interest is paid on debentures are as follows.
— Before commencing operations
— Commencement of operation
— At a particular level of sales/profit
If it is before the commencement of operations, then there won’t be any interest paid.
If it is during the commencement of operations, then a low rate of interest is paid.
If it is during a particular level of sales or profit, then a higher rate of interest is provided.
Debentures can be of two types, namely: convertible debentures and non-convertible debentures.
With convertible debentures, the debt is converted into equity shares and these shares have ownership rights.
On the other hand, non-convertible debentures do not convert debt into equity shares.
Stages
Usually, venture capital financing is offered in various stages of a business, which have been mentioned below.
Seed Stage
This refers to the stage where the business requires funds from venture capitalists so as to improve its growth.
The investor is allowed the examine the business plan and the profitability of the products or services before making an investment.
Start-up Stage
The entrepreneurs, at this stage, come up with an idea on how to provide services that have the potential for success.
Entrepreneurs also need to provide details like:
— Extensive analysis of the revenue model
— Competition in the given sector
— Management details
— Size of the related market
— Potential in the given market
Through an in-depth analysis of all the given details, venture capitalists decide whether or not to invest.
When invested during this stage, the risk involved is extremely high as there is no certainty on the success of the business.
Early Stage
In this stage, the companies are usually emerging and the funds received will be utilized for business activity.
By business activity, I mean that it could be used for improving the inventory or increasing the sales potential.
Expansion Stage
In this stage, the funds received from the venture capitalists are used for business expansion activities.
IPO Stage
This is the last stage, where the company is ready to offer an IPO, and the venture capitalists make money after the IPO has been announced.
Advantages and Disadvantages
Having discussed the general information, now let us have a look at the advantages and the disadvantages of venture capital financing.
Pros
Let us begin by discussing the pros of venture capital financing for investors.
First of all, when the venture is successful, investors may get returns of up to 50%, which is greater than traditional investments.
Nonetheless, there is a significant amount of risk involved, which should be taken into careful consideration.
As new companies often come with innovative ideas, investors are allowed to have access to out-of-the-normal profit sources.
Small businesses acquire all the necessary resources through venture capital investments, which boosts entrepreneurship.
Cons
Now, let us have a look at the disadvantages of venture capital investments.
Usually, there is no secondary market for venture capital investments, which becomes one of the major drawbacks.
It is fine if the venture turned out to be profitable leading to an IPO or a buyout. But when the venture is struggling or fails, then it becomes a problematic situation for the investor.
It is a long-term investment that may not favor the people looking for short-term investment solutions.
The process of determining the market value becomes extremely hard due to the lack of competition in some cases.
The information regarding the companies is going to be limited as the companies are new to the industry.
Private Equity vs Venture Capital
Let us now have a look at some of the key differences between private equity and venture capital.
Business Stage
In private equity investments, the investment is made in companies that have been there for a while.
Such companies are usually struggling or failing in business because of a lack of proper capital for their activities.
Private equities buy such companies and make the operations effective so that they can experience growth and increase their revenues.
However, venture capital firms invest in companies that are in the beginning stage of their business.
Ownership
In general, private equity firms invest in companies so that they can get 100% ownership.
This results in the complete ownership of a company, and the private equity firm will be in total control.
Venture capital financing is done for companies, which offer 50% or less ownership of the company.
In such a scenario, the company owner doesn’t lose control over their business.
Therefore, venture capital firms invest in more than one company. Because of that, even when a company fails, the firm can avoid risk because of being invested in other companies.
Capital
In general, the amount that is invested in a private equity firm can be as high as $100 million on average.
Because of the requirement for such a high amount of capital, these often invest in one company at a time.
However, venture capital firms invest an amount of around $10 million, which allows them to invest in more than one company at a time.
Bottom Line
Both private equity and venture capital financing are deemed high-risk investments even though they offer huge profits.
It is wise to stay from such investments unless you have a huge amount of capital available, and you should also have a high risk tolerance.
Adding to that, even if you have the necessary capital and risk tolerance, it is suggested to limit such investments to a small fraction of your portfolio.
Having said that, I strongly hope that the information provided in this article was helpful for you in finding the information you needed.
Most people usually don’t find the time to take care of their investment needs.
Even if they do, some may not have the necessary skills and expertise to carry out this task.
Therefore, it is wise to leave such aspects in the hands of an effective financial professional.
If you are looking for someone who can handle your investment needs effectively, you are in the right place.
Most of my clients were able to achieve financial freedom with the help of the best-in-class financial services I offer.
If you want to find out whether you can benefit from the expert financial solutions that I provide, then feel free to contact me.
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Adam is an internationally recognised author on financial matters with over 830million answer views on Quora, a widely sold book on Amazon, and a contributor on Forbes.
