Private equity and venture capital: what they are and the differences for startup founders

We need to start with a truth pill that's hard to swallow.
Unless you were a trust fund baby, bootstrapping will only take you so far, Jaime.

Sooner rather than later, your startup will need money. That is, if you wanna succeed at the difficult task of finding the pot of gold at the end of the rainbow product-market fit. And after that, growing quickly and becoming the market leader.

Still, that doesn't mean you'll get any money on the market for your startup. Good founders understand and check the pros and cons of each financing option available.

You're sure to find two of these financing options in your journey as a tech entrepreneur: venture capital and private equity. For close friends, VC and PE.

To become a top founder when we talk about fundraising, it's essential to know what is private equity and venture capital, the difference between them, how PE and VC firms work, and what are the pros and cons of these financing options for startups. Wanna get that check for your biz? This guide is your starting point.

What is private equity and venture capital?

Private equity and venture capital are like cousins. And as with every family relationship, there are big similarities and equally big differences. Given this contrast, consider yourself as a founder and your startup's situation before deciding between PE and VC.

Venture capital

Venture capital is made by people and firms that put money into endeavors known as startups. The definition of venture capital is investing in a temporary organization searching for a repeatable and scalable business model. (We're taking Steve Blank's definition of startup here.)

A venture capital fund works like every other investment fund. Managers select, receive, and manage money from investors in exchange for some fees. The difference seen in VC funds is that the capital is used to choose and buy pieces of startups.

Managers hope that these shares will increase in value over time. And that years after the initial investment, they can distribute returns. The gains should compensate for the risks taken by them and the investors. These distributions can only happen in certain moments, known as liquidity events or exits.

Venture capital was only a thing for Silicon Valley back in the 1950s. The good news is that we've evolved a lot in the past decades. VC is now a very viable option for early-stage startup founders that have big ambitions for Latin America. Yes, we're talking about you!

VCs are behind the 1,000+ unicorns around the world, almost 40 of them in LatAm. But it's worth remembering something right now…

... VCs are also behind a lot of startups that have failed. And it's all good.
What do you mean, all good???

Here comes another truth pill. Only 2% of startups that raise over US$500k become a unicorn in the US. Make it 1% in Latin America. Less than 0,1% of startups explain 97% of all profit generated by these types of companies.

VCs know this truth as well. Some startups will fail. Some will return what they've invested and that's it. Some will provide a small return on the investment. And finally, there's the reason why they chose venture capital. The few remaining startups will do so, but so well that they'll compensate for all the average and even the bad results.

These are the fund returns: startups that grow to the point of having massive success (and a great liquidity event). They can be bought by a competitor (M&A), do an initial public offering (IPO), or attract private equity funds. Yeah, it's their turn now!

Private equity

We need to go even further in time to talk about how private equity started ⏰. The first private equity initiatives began at the turn of the 19th to the 20th century. It was an investment into giants that could support the US' infrastructure development back then. The first registers of private equity are in the steel and vehicle industries.

Private equity funds work just like venture capital funds. Both of them manage money from a bunch of investors in exchange for management and performance fees. Both invest in businesses in exchange for some of their equity. And both believe that equity will be worth much more in the long run.

But there are still some differences between venture capital and private equity. They show why PE goes after VC in a startup's life. Let's check out the main distinctions:

Difference between private equity and venture capital

1. Investment stages and risks

The first difference is in the stage of investment. Private equity firms support companies that are more mature than what venture capital firms are looking for. Companies with established operations and cash flow, that only need capital to finance some scaling strategies that are already well-planned. And by receiving money, they should grow and yield returns. Restructuring, acquisition, and internationalization are some examples of these scaling strategies.

The preference for mature companies goes strong even in growth equity, a subdivision of private equity. Growth equity looks at businesses that are between what venture capital and private equity firms want. These companies present commercially viable products and business models in mature markets. But they still face management and execution risks that might affect their growth and profitability. Scalability is more a possibility than a certainty. That's less common in traditional private equity.

Finally, venture capital looks for young and innovative companies. Some firms invest in startups that only exist in a PowerPoint presentation. The risk is obviously bigger. But so is the potential return on investment. These startups still have a long way to go, and so the money invested can multiply by many times.

2. Bigger checks

The amount of capital invested by venture capital and private equity managers is also quite different. A PE fund puts more money than a VC per check.

And why is that? As we said, private equity looks for more mature companies. They demand more cash to execute more ambitious expansion plans. So PEs enter late-stage, more advanced investment rounds. In general, the check for a private equity round is in the hundreds of millions of dollars. A “standard” venture capital round shells out at most a few tens of millions.

It's worth noting that the boundaries between VC and PE can be much smaller. That happens when VCs decide to expand to more advanced rounds. Or when PEs decide to bet on less mature companies. In these more nebulous stages, notably Series B,  managers even begin to compete with each other for the 🔥 hottest opportunities 🔥.

3. Smaller portfolios, bigger responsibilities

Private equity funds also usually focus on a smaller portfolio than venture capital funds.

Yes, this happens because private equity needs to invest more money in each business. But also because PE managers tend to be a bigger part of the invested companies' daily life.

Private equity firms rely on a combination of money raised from their investors and their own management principles. They have guides to take decisions on cost-cutting, M&A strategies, and investments in new business fronts. That's also why it's normal for  PE managers to pick trusted executives for strategic positions, such as CEO, CFO, and COO.

They wanna shake the foundations 🏛️. Since they have to dedicate themselves more to each invested business, their portfolio is also smaller.

Venture capitalists don't take part that much in the corporate day-to-day. Rather than deciding who does what within the startup, VC firms like to provide access to knowledge and good contacts. Then, the current team can decide for themselves which paths make sense. The presence in the business routine is smaller. And this makes room for investing less but in more startups.

4. Shares in each startup

The percentage of ownership is another big distinction between venture capital and private equity. VC funds maintain a minority stake in the business. They even value that entrepreneurs keep the biggest slice of the pie because then they feel more motivated. In contrast, the private equity model demands that the fund have a dominant stake in the cap table. That allows it to influence the decisions that need to be taken - many of them difficult ones.

5. Segment of choice

Be it venture capital or private equity, each manager has their own thesis. And they only invest in and support businesses that fit them.

Having a thesis means that the manager has investment principles. This may involve decisions like the company's segment, the region where it operates, and its business moment.

An important difference in the thesis is that venture capital managers invest mostly in technology-based businesses. On the other hand, private equity companies are more “agnostic”. Several give preference to companies in traditional markets. There are even PE firms specializing in family businesses.

Private equity and venture capital firms: how do they work?

Before looking for a manager of any kind, entrepreneurs must know how the private equity and venture capital industries work.

One of the most important points is how these managers look for the best opportunities. And what you need to do to be one of them, of course.

Remember how VCs and PEs buy a slice of a business, watch the growth of the pie, and expect the moment they can convert their piece into cash in their pockets?

The goal of every fund is to give a return to its managers and investors. That happens when the purchased slice is worth much more at the liquidity event. That's why the money raised only goes to startups that are fund returners, with a clear exit potential.

There are several steps startups go through to convince VC and PE firms. Each new stage is an opportunity for managers to think twice and favor one business over another. That's why the startup selection process has the familiar shape of a narrow funnel. To close just one investment, it's common to say or receive dozens and even hundreds of no's.

Preparing for each step is essential. So let's summarize what are the main steps that startups go through to get that dreamed VC or PE check:

1. Deal flow and deal sourcing

Your life isn't a walk in the park. We know.

But between us: the life of a VC or a PE isn't just about collecting Patagonia coats either.

VCs and PEs do a thorough analysis of several startups. They need to put third-party money only in those that have a high return potential. And they will answer for it in the next decade.

The first strategy to improve the chances of good returns is to broaden the search range. The more opportunities analyzed, the greater the chances of finding good deals. This stream of opportunities that reach investors is known as deal flow.

But they also can't live waiting for opportunities to fall from the sky. Each manager also has their own deal sourcing tactic, aimed at generating opportunities. The strategies can go from relationships with entrepreneurs and other managers that can give the best “tips” about good business (warm intros) to the use of digital tools for startup mapping and communication (cold intros).

Just remembered how your profiles on Crunchbase, Pitchbook, or good old LinkedIn are gathering dust? Update them right now. We'll wait for you right here.

2. Pitch and signals

After a successful introduction, you'll have meetings with investors. Traditionally, this involves creating a pitch deck. You present the problem, the founding team, the business model, growth and revenue generation strategies, and what you'll achieve with the check in your hands.

This pitch deck must contain signals. Signals are evidence that your startup is in a promising market and that it knows how to solve customer pains in a way that no other company does. These signs can range from past experiences of the founders to relevant numbers.

Signals are fundamental to seducing any VC or PE. Actively work on identifying and publicizing your best signals.

That's just one of the tips we received from Marcial Fraga. Latitud's VC shared the lessons he learned from reviewing over 1,000 pitches with the Latitud Community.

3. Due diligence

Don't stop at presenting a pretty story, though. VC and PE teams usually do very detailed research to see if what you said wasn't just sales talk. This research is the famous due diligence.

Yes, you struggled a lot to get your pitch out there and move on to the in-depth analysis phase. But the bar remains high. Many startups don't make it past due diligence because they haven't cleaned their house well enough to defend projections with confidence. Don't let your startup fall into the same trap. Organize your finances from day zero.

4. Term sheet

Once your numbers and strategies receive the green light, you're almost there. You should now receive a term sheet. That's a document that details the conditions of the investment.

The term sheet serves as the basis for more detailed and legally-binding contracts. Some of the most common themes in term sheets are equity ownership and valuation.

You should always have a lawyer on your side before committing to anything. But even with specialized help, do not leave the room without understanding everything that's written. Learn the most common pitfalls seen in term sheets so that you can spot bad signals from afar, and be in a better position to negotiate terms with VCs.

5. Value maximization

After shaking hands, venture capital and private equity investors help startups to grow. This support is quite different between VCs and PEs, as we've mentioned.

VCs contribute with knowledge and connections. They encourage founders' autonomy. On the other hand, PEs carry out more interventions, based on proven value-enhancing formulas.

Private equity tends to focus on three main areas, depending on the manager's experience and objectives:

Financial: executives appointed by the private equity manager exercise control over each line of the startup's spreadsheets. They look for debts to exchange, payment dynamics to transform, and expenses to cut. Any change that could represent a gain in the last line will be on the radar. They have the ✂️ scissors in their hands ✂️.

Operational: some PE managers have a lot of experience in bringing new paths to the business. For example, making an industry open stores or a traditional business go digital. Making strategic changes that impact daily operations is a common job of PE managers. Their goal is to maximize the value of each invested startup.

Governance: executives restructure the way the company works. Founders and C-Levels might have to report to a board. They can also demand new protocols to make the company become more efficient or transparent.

Good governance work is fundamental to guarantee a good liquidity event. Ans we'll talk about exits below.

6. Liquidity events (exits)

Managers put a lot of time and effort into selecting and managing investments. They do all this to get the highest return possible at the time of getting their money back.

The divestment only happens when VCs and PEs find an opportunity to pass on their shares. That's called a liquidity event or exit.

There are several ways for an investor to get an exit. The most common are mergers and acquisitions (M&As) or initial public offerings (IPOs).

That's when everything goes as planned. What happens when the relationship between founders and investors doesn't go so well? Well, there are three paths.

The first is the buyback, when entrepreneurs buy back their stake in the company. The second is the sale of the stake in the company to another manager that's more interested in the startup. Finally, we have the write-off. That's when VCs or PEs consider the investment is a lost cause and give up their share in it.

Private equity and venture capital numbers in Latin America

After a heated 2021, global economic uncertainties caused both VC and PE managers to reduce the volume of their contributions in 2022.

In Latin America, private capital investors (a class that includes venture capital and private equity) invested US$ 28.2B over 1,352 rounds. In 2021, it was US$ 29.9 billion spread through 1,174 rounds.

In other words: the amount invested decreased a little but went to many more companies. As a result, entrepreneurs saw smaller checks than before. Keep expecting this scenario. For now, 2023 is repeating last year's trend.

Pros and cons of private equity and venture capital for startups

Every money has a cost. Yes, you aren't paying interest like when you get a loan from a bank. But that doesn't mean that venture capital and private equity investors give money free of worries.

Investors want returns. They will pressure your startup to grow until it reaches a level that'll make it attractive to the next buyers.

You've come this far and you're sure you're looking for foreign investment in your startup. But you're still not sure what you have to gain or lose if you choose PE or VC funds? Should you stick to the good old bank credit?

Here's a summary of the pros and cons of both private equity and venture capital:

Private equity is for your startup if…

- Your business reached a good level of maturity. It has a well-defined product and consistent revenue in an established market. There's a real possibility of an IPO in a few years;

- You're willing to lose control of the company. That can happen either by selling a majority of the shares or by the entrance of executives with decision-making power.

Private equity is not for your startup if…

- You operate in a market or with a business model that still has a high degree of uncertainty;

- You want to continue in the business without giving decision-making power to a new partner, via equity or a seat on the board.

Venture capital is for your startup if…

- You need educational and financial help to validate and grow your business as quickly as possible, in a competitive market. Good advice and connections with mentors and strategic players can have the same or greater weight than capital;

- You want to receive external investment but you also want shareholder control of your business. You value some autonomy in management.

Venture capital is not for your startup if…

- You're not open to having someone look at results and pressure you for more speed or consistency of growth. Yes, you'll maintain autonomy but you will still be accountable;

- You have neither the time nor the dedication to cultivate relationships with VCs. Before any VC writes a check, they will want to know you and your startup very well. The selection funnel is narrow and you'll have to talk to several VCs at the same time to guarantee a check. Fundraising is a process that takes over the founder's agenda for months. It's also full of stressful moments. Be physically and psychologically prepared for this journey.