What are they and what is the difference between the two?

If you are a greedy, merciless, and macabre lover of capitalism like we are, you would be familiar with the notion of ‘higher the risk, higher the reward.’ It is one of the fundamental tenets of a working financial landscape. It is also how most companies become successful. Here is how most of the top tier companies, firms, and organizations start out. 

A person or a group of people start with an idea and decide to take that idea out on a date until it delivers a solid structure. Now, for it to get that structure, it requires 'capital', which is a cute, formal and nuanced way of saying money. Now the people who band their labour together to form this company may not always have money, so they go up to people who already have money. Sometimes, it is a loan from a bank. But sometimes, you want more than money, sometimes you want a compass for financial yield. So, you go up to people with money and experience and ask them to inject capital into your company and in return, you will give them a slice of your profits, which you will get, rendered by their direction, advice, or even solely their money. This is called venture capital. 

Let us say you already have an established company. Maybe it is on the stock exchange, maybe it is not. Being on the stock exchange means anyone can invest in them and get stocks or mutual funds in return, who can buy, sell or trade them. But some companies are not listed on the stock exchange, which means they do not receive money from the general population, but from specific private parties. If they are established and are facing some inefficiency or need a fresh injection of liquidity, here’s where private equity comes in. While venture capital is mostly for fledgling companies, private equity is for mature companies in traditional sectors.

Both private equity and venture capital raise lots of money from accredited investors. Why do they invest? Because they want their money back tenfold and their incentive to do that is to increase the value of the business they invest in and when they feel like they’ve done with it, sell their stake and make their profit.  

Let us reiterate the minute differences between private equity and venture capital. 

• The age of the company: Venture capital deals with minors (new companies), whereas private equity deals in cougars (older companies).
• The equity: Venture capital usually have a minor stake in the company, like 10 or 15% but private equity has a majority stake of 51% and higher.

How does venture capital work?

Since fledgling companies are new, fresh and inexperienced, it is a little riskier investing in these, but usually, investors see some potential or promise in them, as it is early-stage financing of young entrepreneurs with the hope of a high rate of return. When you have your new business and you probably fail to attract financial support from existing sources of finance, you turn to venture capitalists and they give you funds, as well as managerial advice, contacts and direction. They share the risks and rewards with you and must be fairly compensated for doing that. It is the financial version of Marilyn Monroe’s “If you can’t handle me at my worst, you don’t deserve me at my best.” This commercialization of new ideas and technology is a unique approach and differs from traditional stock market investors or conventional bankers. 

When your new venture takes off and reaches its highest potential, the venture capitalist decides to disinvest their holdings either to you, the promoter or to the market at a high premium. Either way, they will make a lot of money because they invested the risk, held your hand and watched your company grow up. Case in point: Sequoia Capital decided to invest $37 million into a restaurant and review site called Zomato. As expected, they delivered on time.

How does private equity work?

Just like venture capitalists, private equity investors also raise pools of capital from limited partners to form a fund and then go on to invest that capital into privately-owned companies, which are either doing promisingly well and need money for new ventures or are struggling, stagnating, potentially distressed and need help but still have potential to succeed and grow. Some of these companies are public companies on the stock exchange and when they have private equity, they are delisted from the stock exchange and become private equity. 

The most common structure would be a leveraged buyout (LBO). Here, the investor buys a majority stake in a company with a dovetail of equity and a significant amount of debt, which the company must eventually repay. In the interim, the investor works to create and improve the profitability of the company, so that debt repayment is less of a financial burden on the company. Then when the company has done what it set out to do, the PE firm sells its stake to another company or investor, the firm hopefully has a profit and distributes its returns to the investors. In fact, a private company can become a public company again. Case in point: the Carlyle Group bought a stake in Metropolis Healthcare, a set of pathology labs and fittingly enough, injected liquidity of around $1.3 billion.

Isn’t that beautiful, a neat little process tied with a bow? Again, everyone wins.

Can private equity and venture capital work together?

Of course, but not at the same time for the same company. While it's a private market and capital flows, moving from one entity to another, crushing holes and making ends meet. A company injected with VC can later be injected with PE. No cotton swab is needed. This helps their growth and transition phase. Hence, private equity and venture capital are instrumental in the workings of the financial market. They promote innovative ventures, raise productivity, reduce cost and raise the competitive capacity of companies. They are risky but promising. And for that reason, I am in.