Bearing fruit from private equity: The difference between venture capital and growth equity
By utilizing Crystal’s private equity platform, and a conflict-free manager selection process, advisors have the flexibility to access private equity funds that invest in different stages of a company’s life cycle.
Private Equity Landscape in the Business Cycle Framework
What is Venture Capital?
Venture capital begins with early stage, pre-revenue companies and extends through later stage VC when a company develops a product and begins generating revenue.
Venture capital consists of investments in new products and services where the objective is to achieve outsized returns from investing in the next must-have technology, breakthrough drug discovery or massive consumer trend. These young, often tech-focused companies are growing rapidly, and VC firms will provide funding in exchange for a minority stake of equity—less than 50% ownership—in these businesses.
This type of strategy tends to have the highest dispersion of returns with losses being offset by outsized winners. While venture capital holds the potential for huge wins, it also risks big losses for investors that participate. The high-risk nature of venture capital investments is determined by several risk characteristics, most notably market and product risks. Such risks are associated with operations in new markets and the absence of a commercially viable product.
What are the Advantages of Venture Capital?
For newer companies or those with a short operating history, venture capital funding is both popular and sometimes necessary for raising capital. This is particularly the case if the company does not have access to traditional sources of financing such as bank loans, or other debt instruments. In addition to providing capital, investors often take board seats and provide operational and strategic guidance to their portfolio companies.
What is Growth Equity?
Growth equity is the next phase of a company’s lifecycle when the risk shifts from whether a product will gain market adoption to whether it can be sold profitably. Such companies might not be cash-flow positive at the point of investment but would be expected to be so at some point in the future.
Growth equity resides in between venture capital and buyout strategies on the continuum of private equity investing. Growth equity (or growth capital) is designed to facilitate the target company’s accelerated growth through expanding operations, entering new markets, or consummating strategic acquisitions.
Companies targeted in growth equity deals generally have an established, viable product or service and are looking to disrupt incumbents. However, the execution and management risks of such types of deals are still high.
What are the Benefits of Growth Equity?
When properly sourced, diligenced, negotiated and executed, growth equity can represent a lower risk-adjusted source of returns for investors relative to earlier stage venture capital investments. Growth equity investments should provide a steadier return stream than venture capital. Although growth equity provides investors with a lower probability for large losses, it is also associated with a lower probability for outsized returns as compared to VC investing.
Similarly, by attracting cost-effective capital and a skilled and seasoned partner, growth capital often represents an attractive financing source for businesses poised to accelerate their revenue and profitability growth. Similar to venture capital, the companies accepting growth equity capital, also expect to gain insight from the firms that are investing in their businesses. GPs of growth equity funds often serve on boards and provide informal consultation and advice to the owners of the invested businesses.
This means that the business owners can leverage their investors’ experience and insights to effectively improve their operations. Plus, many small business owners also get the resources that they need to expand their company.
Private Equity Investing @ a Glance
|Venture Capital||Growth Equity||Buyout|
|Objective||Invest in early stage, pre-revenue companies with unproven business models and extends through late stage when a company develops a product and begins generating revenue||Invest in operating companies with established end markets. Invest at inflection point where growth capital can fuel substantial revenue and profitability growth||Invest in mature operating companies with proven business models. Invest at a point where steady cash flow can be improved through operational/governance improvements|
|Investment Thesis||Investment theses underwritten on substantial revenue growth projections||Investment theses underwritten on defined plan to achieve profitability potential||Investment theses underwritten on stable cash flow and debt repayment|
|Deal Size||Typically invest in a minority equity position||Invest in a minority equity position||Invest in a controlling (or exclusive) equity position|
|Target Acquisitions||Invest in non-profitable companies with no free cash flow||Invest in operating companies with limited or no free cash flow||Focuses on companies with years of proven cash flow|
|Financing||No debt financing||Minimal or no funded debt||Often employ debt financing|
|Investment Risks||Market and product risks||Execution and management risks||Credit default risk|