For prospective young entrepreneurs, the question of financing is as important as a good business idea. In addition to loans, crowdfunding, private equity, or venture capital is usually mentioned. But how exactly does that work?
Financing: how do private equity and venture capital work?
Venture capital and private equity are similar in concept as they both represent a type of capital that helps to facilitate the growth of the company in which they are invested. The mechanisms of venture financing of entrepreneurial projects have been widely used in practice for more than a decade and have become more widespread in recent years.
Historically, various forms of entrepreneurship arose and developed based on private capital, which was combined in one way or another, depending on the level of development of social production.
What is private equity?
Private equity companies look for companies with a good balance between risk and return. A high and stable cash flow is also important. As a result, higher returns are expected than are usually achieved on the money market.
Private equity companies collect money from private or institutional investors (through co-financing with banks and investors). The capital is used to buy company shares to increase the capital employed. It can be achieved by optimizing an existing business or by investing in a profitable business straight away. Private equity companies look for companies with a good balance between risk and return. A high and stable cash flow is also important. Higher returns are expected than are usually achieved on the money market.
What is venture capital?
Venture capital is a unique form of private equity. Venture business – investing, usually in the form of equity capital, in high-growth enterprises demonstrating the potential, one of the main forms of implementation of technological innovations. This type of entrepreneurship is largely typical for the commercialization of the results of scientific research in science-intensive and, above all, high-tech areas, where prospects are not guaranteed, and there is a significant amount of risk.
Venture capital is typically the seed capital provided to high-growth potential, high-risk companies. Venture capital is very important for small start-ups that do not have access to other forms of capital that can be obtained by selling securities on financial markets or borrowing from banks.
Investing in a start-up by venture capital investors is risky, with a high probability of failure. It is because the purpose of venture capital is to obtain a high return on investment, which investors receive in the vast majority of cases not in the form of dividends but the form of a return on investment when selling after several years of successful development of their share of the company to business partners, on the open market or a large company operating in the same area as the growing firm.
Private equity vs. venture capital: do you know the difference?
Venture capital and private equity are two terms that are often confused. Even if they often overlap in practice and are even used as synonyms by experts, the differences are extremely important, especially for investors. As a result, these concepts are used in different scenarios:
- The venture capitalist will hold a portion of the equity of the companies in which investments are made and will be entitled to shares in the company if they choose to list shares on a stock exchange.
- Venture capitalists invest in high-risk, start-up companies, but private equity investors choose more stable and established companies with a lower level of risk. In addition, the waiting time for a private equity investor will be shorter as the investment will be made in a more stable, mature, and established company.